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Dynamic Asset Allocation

Handbook

March 2017

farrelly’s Dynamic Asset Allocation Handbook - Mar 2017 I Available exclusively through PortfolioConstruction.com.au I

EXECUTIVE SUMMARY

Disclaimer, disclosure and copyright © 2016 Farrelly Research & Management Pty Ltd (‘farrelly’s’) ABN 63 272 849 277. All rights reserved. Reproduction in whole or in

part is not allowed in any form without the prior written permission from farrelly’s. This document is for the exclusive use of the person to whom it is provided by farrelly’s

and must not be used or relied upon by any other person. This document is designed for and intended for use by Australian residents whose primary business is the

authorised provision of securities advice as that term is defined in Corporations Regulations and, in particular, is not intended for use by retail investors. The material is

not intended to be investment advice (either personal or general), a securities recommendation, legal advice, accounting advice or tax advice. The document has

been prepared for general information only and without regard to any particular individual’s investment objectives, financial situation, attitudes or needs. It is intended

merely as an aid to financial advisers in the making of broad asset allocation decisions. Before making any investment decision, an investor or prospective investor

needs to consider with or without the assistance of a securities adviser whether an investment is appropriate in light of the investor’s particular investment objectives,

financial circumstances, attitudes and needs. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the infor-

mation contained in this document, which is based solely on public information that has not been verified by farrelly’s. The conclusions contained in this document are

reasonably held at the time of completion but are subject to change without notice and farrelly’s assumes no obligation to update this document. Except for any

liability which cannot be excluded, farrelly’s, its directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error or inaccuracy in,

or omission from, the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying

upon the information.

Tim Farrelly Available exclusively through

Principal, farrelly’s PortfolioConstruction Forum

+61 416 237 341 +61 2 9247 5536

[email protected]

Part 1

Executive Summary 3

Tipping Point Tables 5

7 Editor’s Update - The outlook for residential property

farrelly’s Forecasts

- Occam’s Razor approach to forecasting 16

- The long-term outlook for markets 17

- The long-term outlook for commercial property 19

- farrelly’s long-term risk assumptions 28

Crockpot – Negative gearing and high property prices 29

Part 2

Implementation – more than one way to skin a cat 31

Directed Approach – The Model Allocations

- Explanation 32

- Model Allocations 33

Advised Approach – Swim between the flags

- Explanation 34


Bespoke Approach – Plot your own course

- Explanation 36

39

NZ-domiciled investor supplement 40


EDITOR’S UPDATE

Executive Summary

Tipping Points - All major asset classes are at Fair Value, with Emerging Market Equities

and A-REITs on the edge of becoming Fully Priced. US Equities are Fully Priced. Australian

Equities are not far from Fair Value.

Model Asset Allocation changes - We have seen a small allocation away from At Risk

Debt in response to falling credit spreads over the past year.

Editorial - This quarter’s Editorial reviews the outlook for residential property and finds that

falling interest rates have been the primary driver behind the strong returns over the past

30 years. Now that interest rates have nowhere left to fall, future returns are likely to be

extremely modest. This Editorial will be made available as a separate document for

subscribers who wish to send it to clients. The tone is somewhat different from usual as it is

primarily aimed at investors rather than subscribers.

Forecasts in Focus - This quarter we review the long-term outlook for Commercial

Property, including A-REITs, global REITs and direct property investments. Expected returns

for A-REITs and global REITs are similar, and some opportunities are still available in direct

property where valuers seem to be struggling to keep up with a fast moving market. The

direct property boom still has room to run.

Crockpot - Crockpot focuses on the idea that negative gearing is responsible for high

residential property prices and that removing it will make a substantial improvement to

housing affordability. farrelly’s believes that rising prices drive negative gearing rather

than the other way around. Removing it will do little for affordability.

Asset class Index & 10-yr return Status Asset allocation implications

Index level (f) %pa

Risk premium between 2.5% and 5% per annum.

Overweight this asset class compared to neutral weights.


Neutral weight this asset class.


Underweight this asset class. While it is Fair Value, long-term

risks are unusually high at present.


Modest underweight this asset class compared to neutral

weights.

Fair Value

Fair Value

Fair Value

Fair Value

All Ords

5850.1

FTSE DM

273.5

FTSE EM

619.16

ASX REIT

1371.8

Australian Equities

Developed

Market Equities

Emerging Market

Equities

A-REITs

8.2%

6.8%

6.1%

6.1%


EXECUTIVE SUMMARY

Summary of changes in farrelly’s Forecast assumptions over the past quarter

The major change to the assumptions underlying the farrelly’s Forecasts is an increase

in the range of possible outcomes from markets over the next decade due to the

unpredictable Mr Trump in particular, and the rise of populist political parties in general.

In addition, there has been a small increase in the expected EPS growth rate for

Developed Market Equities to reflect the impact of the expected Trump corporate tax

cuts and deregulation.

Revised Tipping Point Tables

The Tipping Point Tables for Developed Market Equities now uses the FTSE All World

Developed Markets (Local Currency) as its reference index, to reduce the confusion

caused by our previous use of the S&P500 as the reference index for the broader

Developed Markets forecast. The forecast methodology is unchanged, the constituents

of the index being forecast are unchanged. The only change are the numbers running

down the side of the Tipping Point Table.

This new index can be found in the same place as the FTSE All World Emerging Markets

Index (Local Currency).

Australian equities 10-yr forecast return 8.2% 9.1% Market rose by 7.9%

Dividend assumption 5.6% 5.7% Market rose by 7.9% offset by div increase

Terminal PE assumption 16.7 16.7 No change

EPS growth assumption 3.2% 3.7% Less mean reversion

Developed Market 10-yr forecast return 6.8% 7.9% Market rose by 8.6%

Equities Dividend assumption 2.4% 2.6% Market rose

Currency 1.1% 1.1% No change


EPS growth assumption 4.8% 4.4% Inpact of Trump policies on US EPS

Emerging Market 10-yr forecast return 6.1% 7.0% Market rose by 9.1%

Equities Dividend assumption 2.8% 3.1% Market rose

Currency 0.0% 0.0% No change


EPS growth assumption 4.6% 4.1% Higher mean reversion assumption

A-REITs 10-yr forecast return 6.1% 6.8% Market rose by 7.1%

Dividend assumption 4.7% 4.9% Rising market = lower dividend yield

Terminal yield assumption 5.1% 5.1% No change

Dividend growth 2.3% 2.3% No change

Aust interest rates Aust TD rates 3.3% 3.3% No change

Aust cash rates 2.5% 2.5% No change

Aust Inflation 2.3% 2.3% No change

NZ interest rates NZ TD rates 4.2% 3.6% Higher TD rates

NZ cash rates 3.3% 3.5% Lower OCR

NZ inflation 2.0% 2.0% No change

Assumptions Mar-17 Dec-16 Reason for change


EDITOR’S UPDATE

Tipping Points

These Tipping Point Tables summarise the outcomes of the farrelly’s forecasting process and, in particular, how

the farrelly’s forecasts would change as markets change.

Cheap Fair Value Fully Priced Overpriced

Forecast 5%pa or

more above TDs

Forecast 2.5% to

5.0%pa above TDs

Forecast 0% to

2.5%pa above TDs

Forecast return

lower than TDs

All Ords FTSE DM FTSE EM ASX REIT

5,850.10 273.5 619.16 1371.8

10250 0.3% 370 3.2% 1000 0.4% 1700 3.1%

9750 1.0% 360 3.5% 950 0.9% 1650 3.5%

9250 1.6% 350 3.8% 900 1.6% 1600 3.9%

8750 2.4% 340 4.2% 850 2.2% 1550 4.4%

8250 3.2% 330 4.5% 800 3.0% 1500 4.9%

7750 4.0% 320 4.9% 775 3.3% 1450 5.3%

7500 4.5% 310 5.3% 750 3.7% 1400 5.8%

7250 5.0% 300 5.7% 725 4.1% u 1375 6.1%

7000 5.5% 290 6.1% 700 4.6% 1350 6.4%

6750 6.0% 280 6.5% 675 5.0% 1325 6.7%

6500 6.6% u 270 7.0% 650 5.5% 1300 6.9%

6250 7.2% 260 7.4% u 625 6.0% 1275 7.2%

6000 7.8% 250 7.9% 600 6.5% 1250 7.5%

u 5750 8.4% 240 8.4% 575 7.1% 1225 7.8%

5500 9.2% 230 9.0% 550 7.7% 1200 8.2%

5250 9.9% 220 9.6% 525 8.3% 1175 8.5%

5000 10.7% 210 10.2% 500 9.0% 1150 8.8%

Australian EquitiesDeveloped Market

EquitiesA-REITsEmerging Market Equities

10-year

F'cast return

10-year F'cast

return

10-year F'cast

return

10-year F'cast

return


farrelly’s FORECASTS

The Tipping Point Tables are an excellent tool for illustrating to investors the current

valuation status of markets. The more we pay, the lower returns we get; the less we

pay, the better returns we get.

Currently, Australian Equities are rated on the border of Cheap and Fair Value.

Within Developed Market Equities, the US market is Fully Priced while the rest of the

world (effectively represented by the FTSE All World Developed Markets (ex US) or the

MSCI EAFE index) is much better value.

Emerging Market Equities are now Fair Value. However, an underweight rather than an

overweight position is appropriate as long-term risks remain unusually high at present,

as discussed in the Forecasts in Focus section in the December 2016 edition of this

Handbook.

A-REITs are still just in Fair Value range. They remain vulnerable to a spike in bond rates.

Overall exposures to Risky Assets should be around neutral weights. Enough asset

classes are rated Fair Value to warrant an overall fully invested position in Risky Assets.

Note on changing asset allocations

Where making changes to portfolios as a result of relative over- or under-valuations, the

key is to move slowly. Generally, take between 18 months to two years to gradually

implement a change. This is because valuations tell us nothing about when an asset is

likely to over- or under-perform. Often, the forces that drive an asset to being Very

Cheap or Very Overpriced will persist well after an asset has moved to being either

Cheap or Overpriced. As a result, it generally pays to stagger transactions over time

when selling down or buying assets to take advantage of prices going from Overpriced

to Very Overpriced, or from Cheap to Very Cheap.

TIPPING POINTS


EDITOR’S UPDATE

Editor’s Update

The outlook for residential property

“If returns came out of history books, then librarians would be the richest folks around”

Warren Buffett

Residential property has been a wonderful investment for millions of Australians over the

past 30 years and longer.

So much so, that investors know that, despite minor short-term slow-downs, residential

property will always show excellent capital gains in the long term. They know this

because it always has been this way in the past. Their parents bought their first house for

four thousand pounds and it’s now worth over a million dollars. Every house they have

ever bought has made money. And, better still, everyone they know has made money

on residential property. Not most people - everybody. Investing in residential property

makes you rich. It’s an historical fact!

Well, almost. Unless they have been very unlucky, past investors in residential property

have done well and that is an historical fact. As is shown in Figure 1, capital growth has

been exceptional for a long period of time.

However, as Warren Buffett also noted, past returns and future returns are quite different

things.

This Editorial looks to understand past returns from residential property and then to use

that understanding as a basis for forecasting future returns. To understand where the

price rises came from, it helps to be able to break apart the role of fundamental factors,

such as growth in rents, from market factors, such as how much the market is prepared

to pay for a dollar of rent.

Figure 1: Capital gains on median three bedroom house prices (%pa)

Period Sydney Melb Bris Adel Perth Canb

1985 - 2016 8.1% 7.5% 7.0% 5.8% 7.6% 6.0%

2005 - 2016 10.0% 9.6% 9.1% 9.8% 9.8% 9.2%

2015 - 2016 7.0% 6.6% 4.1% 4.4% 4.3% 3.9%

Source: Real Estate Institute of Australia, farrelly’s analysis


EDITOR’S UPDATE

In essence, this approach says that the price of a property is determined by net rents

multiplied by the amount the market is prepared to pay for each dollar of rent. We call

this the Rent Multiple. If we have a property that produces $10,000 per year in net rent

and the market is prepared to pay $40 for each dollar of rent, that property is worth

$400,000. For the property to increase in value, either net rents must increase or the Rent

Multiple must increase - or some combination of the two.

Let’s look at an example using the property described above. If, over the course of a

year, rents rose 3% and the Rent Multiple rose by 5%, the house price would rise by 8%.

This is the increase in rents (3%) plus the increase in the Rent Multiple (5%) as shown in

Figure 2.

Where this approach becomes very useful is in understanding the contribution of each

factor to past growth in property prices. As can be seen in Figure 3, increases in rents

have been very much the junior partner in this exercise. Prices have risen much, much

faster than rents. That is to say that the increases in prices have not been backed up by

increases in the fundamental earning power of property. What has driven the major

part of the price increases is a huge increase in the Rent Multiple.

As outlined earlier, the Rent Multiple is the amount buyers are prepared to pay for each

dollar of rent. The Rent Multiple is the inverse of the yield on a property. The yield is

calculated by dividing net rents by the property value, whereas the Rent Multiple is the

value divided by the net rent. As can be seen in Figure 4 (overpage), a soaring Rent

Multiple means tumbling yields.

Figure 2 : Capital gains on median three bedroom house prices (%pa)

Period $ Annual rent $ Rent multiple $ Property value

I year ago 10,000 40 400,000

Now 10,300 42 432,600

Change +3% +5% +8%

EDITOR’S UPDATE

Figure 3: Capital gains and rental increases on median three bedroom house prices

Sydney Melb Bris Adel Perth Canb

Total % increase

Price increase 1006% 827% 695% 461% 841% 503%

Rent increase 145% 168% 221% 172% 335% 213%

Total Increase % pa

Price growth 8.1% 7.5% 7.0% 5.8% 7.6% 6.0%

Rental growth 3.0% 3.3% 3.9% 3.3% 4.9% 3.8%

Source: RESI, farrelly’s analysis


EDITOR’S UPDATE

Figure 4: The Rent Multiple has soared as yields have tumbled

Clearly, the major driver of increasing housing prices in Sydney and Melbourne has been

the huge expansion of the Rent Multiple. In the case of Sydney houses, the Rent Multiple

has risen from around 15 times rents in the 1980s to a massive 65 times rents today - even

after a period of softer prices. Other capitals have experienced similar increases.

From an institutional investor’s perspective, Sydney residential property is outrageously

expensive. By way of comparison, commercial property trades at around 13 to 20 times

rents and shares trade at about 16 times after-tax profits. As a result, institutional investors

rarely invest in residential property.

Why is residential property so expensive?

farrelly’s believes it is because prices are set by those looking for somewhere to live rather

than conventional investment metrics. Owners of residential property are, of course,

largely owner occupiers, with a fair number of private investors. Both behave very

differently to institutional investors who look at the earnings power of an investment and

the potential for growth in earnings. In trying to make sense of residential property prices,

it helps to think about how residential buyers and sellers go about deciding what to pay or

accept for a property. From there, we will propose a theory of how prices might behave

and then, finally, look at the data and see if our theory translates into the real world.

How home buyers decide what to pay for a property

How much do home buyers pay when looking for a house? The answer? Whatever they

can afford.

Home buyers, after their first day of house hunting, invariably return deflated. “Is our

dream home really that far out of our range? I can’t believe how little we get for our

money.” After that first day, the buyers’ strategy becomes clear - work out the maximum

they can possibly borrow and then go looking for the least worst place they can buy for


EDITOR’S UPDATE

that amount of money. Concepts like yields or the Rent Multiple just don’t come into it.

They just want their own home to live in and in which to raise a family. So what do they

spend? Whatever the bank will lend them.

The banks will assess a loan on the ability of the borrower to pay the interest. They

compare the amount of the borrowers’ weekly income that can be spent on interest

payments with the interest payments required on the amount borrowed. So, if the

borrowers’ earnings rise, or if bank interest rates fall, the banks will lend more to a given

borrower. Similarly, when interest rates rise, banks will lend less for each dollar of income.

Borrowers want to maximize the amount they have to spend on their property and the

banks are only too happy to lend it to them.

When interest rates fall substantially, buyers all over Australia simultaneously find they can

borrow, say, 20% more to buy a fixed number of houses. You would expect that, in this

environment, prices should rise by around 20%. And, more or less, this is what actually

happens, if not immediately.

Note that this only works if the supply of houses is relatively stable. If the supply of houses

responded rapidly to changing prices, bank lending would no longer drive prices to the

extent suggested here. In Australia, we have some nine million dwellings growing at

around a little over 1% per annum - and that is with a building boom underway.

Now, home buyers don’t automatically pay more for a given property just because they

have had a pay rise and can borrow more. In practice, they study the market for a

while, work out what is the going rate for houses in a particular area, and then go

looking for a bargain, or at least something that seems reasonable. Sellers go through a

similar exercise. They find out what other houses in the street have sold for and hope to

get a price a little bit better than that.

The impact of thousands of such buyers, all making similar assessments, will gradually

move prices up when average weekly earnings rise, or if interest rates fall. In the long

term, prices should rise in line with the amount the banks are prepared to lend.

How investors decide what to pay

Because home owners aren’t the only buyers in the market we need to investigate the

market impact of investors, who, as we have discussed, are rarely institutions who worry

about income and how fast that income grows.

Private investors are more concerned with the amount of capital appreciation that may

be achieved over a period of time, without being too concerned where that

appreciation might come from. For a private investor, a bargain is a property that is

cheaper than the house next door, even if both are ridiculously expensive from the

viewpoint of an institutional investor.

Private investors believe that residential property will increase in value. Their experience,

and the experience of just about everyone they know, is that property prices rise in the

long term. So their process for investment turns out to be much the same as home

owners. They work how much they can borrow and find a property at a half decent

price compared to other properties in the area. And the banks’ attitude to them is much

the same - how much interest can you pay and can they pay a deposit?


EDITOR’S UPDATE

Affordability: theory and practice

Our proposal is that in the long-run, prices are set by home loan affordability which can

be best thought of as how much the bank will lend to the average buyer. In effect, we

do something close to the calculation a bank makes before deciding on a loan. The

bank will start with the amount a borrower earns, work out what is left over after living

expenses and therefore available to be used to pay interest, and then divide by the

interest rate payable to arrive at an affordable value, or the amount the bank will lend.

If this works in practice, then we should see long-term prices following a path that is

similar to that of the Affordable Value calculation. We should see prices rising as

average earnings rise and as home loan interest rates fall. In the short-term, prices may

move away from the theoretical Affordable Value - depending on the amount of

buyers and sellers active in the market - but prices should come back over time.

Figure 5 compares actual median house prices around Australia with farrelly’s estimate

of Affordable Value in different states. The results fit the theory well. As expected, in the

short-term, prices seem to take a while to respond to changes in affordability and at

times get driven beyond the levels one would expect if they were set by affordability

alone. But in the long run, prices seem to follow the path set by changes in affordability.

Figure 9 : House prices and Affordable Values

Median weekly earnings x % able to be spent on interest

Affordable Value = ------------------------------------------------------------------------

Home loan interest rates

Source: REIA, ABS, RBA, farrelly’s analysis


EDITOR’S UPDATE

Looking ahead

If affordability continues to be a key driver of residential property prices, then the major

drivers of prices will be wage growth and interest rates, both of which depend to a

large part on inflation.

Inflation

Forecasting inflation is a subject in itself. For the purpose of this report, we will assume

that the RBA and RBNZ continue to have moderate inflation as one of their primary

targets and continue to do an excellent job of keeping it there. Our estimate is for

inflation to remain in the 2% to 3% per annum range, averaging 2.25% per annum, in

Australia and 2.0% per annum in New Zealand. However, it is possible that inflation

could be higher or lower than the targets and so we will also look at the impact of

higher or lower inflation as well as our base forecast.

How fast can wages grow?

The data for average weekly earnings growth compared to inflation is shown below in

Figure 6. What we see is that wages move broadly in line with inflation, generally with

some scope for real growth, usually reflecting productivity increases.

Currently, real wages growth in Australia is very slow, reflecting the sluggish Australian

economy. As the economy gradually improves, we see that picking up, but not too

much. We expect average income growth at around inflation plus 0.75% per annum in

the next decade in Australia.

Interest rates

In the long run, interest rates tend to be driven by many factors, but the key one is

inflation, or expected inflation. It is our expectation that interest rates will increase

modestly over the next decade to, say, 3.0% or 3.5%. Rates may even go higher. What

they will not do is go much lower. Nonetheless, we can test the impact of a range of

different interest rate environments on Affordable Values.

Affordability through to 2027 under different scenarios

We can test the impact on affordability of our base case and for a number of different

scenarios. Nonetheless, given we need either high wages growth or falling interest rates

to drive affordability, even without looking at the numbers, we can quickly see that

Figure 6 : Real Australian wage in average weekly earnings (1986 –2016)

Period Growth in earnings Average CPI increase Real growth in earnings

1986 –1996 5.6% 4.5% 1.1%

1996 –2006 4.4% 2.6% 1.8%

2006 - 2016 3.3% 2.4% 0.9%

Source: ABS,RBA


EDITOR’S UPDATE

growth in affordability is likely to be much slower than in the past. The various scenarios in

Figure 7 make assumptions about what real wages growth and interest rates would be

under different inflation scenarios. And, while the 1.5% to 4.5% range of inflation scenarios

may seem narrow, moving outside those scenarios doesn’t change the remarkable

conclusion from this review that almost regardless of what scenario we look at, the rate of

growth of housing affordability is likely to be extremely low going forward.

This suggests that capital growth is likely to be around 2.5% per annum or less for the next

decade, which, when added to the extremely modest rental yields on offer, suggests very

modest pickings for residential property investors over the next decade, as is summarised

in Figure 8.

While the analysis here is focused on the Australian market, anecdotally the same logic

largely applies for the New Zealand market although farrelly’s lacks the data to back-test

the affordability model in NZ. As can be seen here, the outlook for the Auckland

Figure 7: Forecast changes to affordability under different scenarios (2017– 2027)

Base case 2.5%

inflation

3.5%

inflation

4.5%

inflation

1.5%

inflation

Average inflation (% pa) 2.3 2.5 3.5 4.5 1.5

+Real wages growth (%pa) 0.7 0.7 1.3 1.5 0.3

+Impact of interest rate changes1 -0.7 -1.3 -3.5 -4.4 0.0

Average affordability growth (pa) 2.3% 1.9% 1.3% 1.6% 1.8%

2027 RBA cash rates 3.0 3.5 6.0 7.0 1.5

2027 Bank lending rate 5.5 6.0 8.0 9.0 4.0

Source: farrelly’s forecast

1. An interest rate rise from 5% to 6% would reduce affordability by 20%, or 2%pa over the 10 yr forecast period.

Figure 8 : Forecast returns from residential houses & apartments 2017 to 2027

Period Syd Melb Bris Adel Perth Canb Akl

Net yield on houses1 1.5 1.9 3.1 3.1 3.0 3.2 2.1

Capital growth 2.3 2.3 2.3 2.3 2.3 2.3 2.0

Total return %pa 3.8% 4.2% 5.4% 5.4% 5.3% 5.5% 4.1

Net yield on apts1 3.2 3.1 4.0 3.4 4.4 4.0 na

Affordability growth 2.3 2.3 2.3 2.3 2.3 2.3 na

Total return %pa 5.5% 5.4% 6.3% 5.7% 6.7% 6.3% na

Source: RESI, farrelly’s analysis Note 1. Net yield is gross rents less an allowance for expenses of 0.7%pa


EDITOR’S UPDATE

residential property market looks much the same as that of Melbourne and Sydney, and

for all the same reasons.

What could go wrong with this forecast?

Forecasts are based on assumptions, many of which could prove to be wide of the

mark. In this case, there are many factors that could lower residential property returns

below even these modest forecasts.

What could make returns even lower than forecast?

• Foreign investors become net sellers - this is possible, particularly if the markets show

signs of weakness. In property markets like Hong Kong, investors are notoriously fickle.

However, anecdotally, much of the foreign buying in Australia and New Zealand has

been for lifestyle rather than investment purposes.

• Local investors become fearful, take flight and dump property - again, this is possible,

but unlikely. There is a very strong underlying belief in property as a sound investment.

It would take a long time to break that belief.

• Changes to the capital gains tax treatment or deductibility of interest expenses—

again, this is possible, but unlikely to have too much impact. It may slow new

investors entering the market but any changes would in all likelihood be

grandfathered and so would not effect existing investors.

• Massive overbuilding - there have been signs of this in some suburbs of Sydney,

Melbourne and Brisbane and, if building activity keeps going at current rates, that

certainly would lower returns. However, building approvals are slowing and so the

long-term impact should be modest.

• Even tighter regulatory controls on bank lending practices - this has already been

happening to some extent and has been incorporated into this analysis. Further

tightening of lending standards will further lower capital growth.

• Recession - this could hurt returns in the short term and medium term, as recessions

tend to move the actual value below Affordable Value for a while. On the other

hand, recessions tend not to impact affordability in the long term.

• Much higher interest rates - these would have little impact on nominal returns but

could be devestating for highly geared investors. This is quite unlikely as central banks

will be very cautious about lifting rates too far too fast.

• Legislation aimed at improving housing affordability by reducing housing prices - this

is a real possibility but the impact will be targeted to slow capital growth rather than

reduce prices substantially. This is a political tightrope - don’t expect too much from

our politicians!

• Transaction costs - the cost of buying and selling a house normally comes close to 8%

to 10%, enough to reduce returns by 1% per annum on a 10-year investment. This will

apply to all new investors considering a residential property investment


EDITOR’S UPDATE

What could go right?

Because these forecasts are somewhat pessimistic, instead of worrying about how the

returns might be much lower than forecast, it is possibly more useful to worry about

whether and how returns might be much more attractive than expected.

farrelly’s sees two main catalysts:

• The foreign investment floodgates open - this is possible, but unlikely. The New

Zealand government has been on the housing affordability case for some time, with

limited success it would seem. Now, even Australian politicians have woken up to the

idea that this is a major issue for a large part of the population. Restricting the impact

of foreign investors on affordability is too easy a win. If increased foreign capital flows

was a factor that was really driving property prices, expect it to be shut down quickly.

• The politicians attack the affordability issue by making it easier to buy property - this is

low hanging fruit. First time home buyer grants, allowing banks to ease lending

criteria, allowing superannuation savings to be used to buy a first home - all just make

the affordability issue worse. Again, this seems unlikely as most politicians seemed to

have worked this out. But it is ripe for the populists.

Now is not a great time to be investing in residential property

Low returns, high transaction costs, and the threat of rising borrowing costs all make

Residential Property a dubious proposition at this time, despite magnificent past

performance.


EDITOR’S UPDATE

farrelly’s forecasts

Occam's Razor Approach to market forecasting

In 1991, John Bogle wrote his seminal paper “Investing in the 1990s: Remembrance of

Things Past and Things Yet to Come.” (Journal of Portfolio Management, Spring 1991, pp.

5-14.) He described what he called the Occam’s Razor approach to forecasting,

named after Sir William of Occam, who in the fourteenth century declared the simplest

explanation is generally the best. The Occam’s Razor approach to forecasting

decomposes market returns into three elements: income; growth in income; and, the

effect of changing valuation ratios. This can then be used to explain past returns and,

more interestingly, forecast future returns with remarkable accuracy. The three elements

combine to produce the following formula:

Returns = Income + Growth in income + Effect of changing valuation ratios

R = Y + G + V

Where:

Y is the current investment yield, a known quantity, hence no forecasting is required

for this input.

G is the annualised growth in income or earnings for the asset. For:

Property, it is growth in rents

Equities, it is growth in Earnings Per Share

Fixed interest, growth is zero, by definition!

V is the Valuation Effect. It is the compound effect of an increase or decline in PE

ratios or yields on the returns produced by an asset.

For example

For equities over a one year period:

V = (PE at end of period / PE now ) –1

If PEs rose from 10 to 12 then:

V = 12/10 – 1 = 0.2 or +20%

For longer time periods, say 10 years, we use the compound growth rate:

V (%pa) = (PE at end of period / PE now)1/10 –1

Using the previous example, over 10 years:

V = (12/10)1/10 -1 = 1.0183-1= +1.83% pa

Why use 10-year forecasts? They are more accurate than short-term forecasts. EPS

growth is steadier over 10-year periods than one-year periods. The effect of a change in

PEs is much smaller over 10 years than one year, as we have just seen.



The long-term outlook for markets

The forecasts below are based upon the Occam’s Razor approach outlined on the

previous page. This approach to forecasting has many attractions – including accuracy,

simplicity and transparency. By making available the underlying logic and assumptions

(Figure 1 below), subscribers are able to quickly understand the rationale for the

farrelly’s forecasts and determine the effect of changing the assumptions.

Figure 1: Expected Returns and Risks for Asset Classes - Australian Domiciled Investors, March 2017

Australian

Equities

Developed

Market

Equities

Emerging

Market

Equities

A-REITsSecure

Debt

At Risk

Debt

Fund of

Hedge

Funds

Cash

Yield (pre tax) 5.6% 2.4% 2.8% 4.7% 3.3% 5.5% - 2.5%

+Currency Impact - 1.1% 0.0% - - - - -

+ Earnings growth (f) 3.2% 4.8% 4.6% 2.3% 0.0% -1.5% - -

+ Valuation effect -0.6% -1.5% -1.4% -0.8% 0.0% 0.4% - -

Index return 8.2% 6.8% 6.1% 6.1% 3.3% 4.5% 2.5% 2.5%

+ Manager value add 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.3% 0.0%

Total Return (pre tax) 8.2% 6.8% 6.1% 6.1% 3.3% 4.5% 4.8% 2.5%

Total Return (15% tax) 7.1% 6.0% 5.2% 5.3% 2.8% 3.8% 4.1% 2.1%

Total Return (46.5% tax) 5.0% 4.5% 3.1% 3.8% 1.8% 2.4% 2.6% 1.3%

PE Now 17.8 21.5 16.7

PE 2027 (f) 16.7 18.5 14.6

Yield 2027 (f) 5.1%

Indicative Index All Ords FTSE- DM FTSE -EM ASX REITs

Index Level 5,850.1 273.5 619.2 1,371.8

Worst case scenarios :10 year REAL total return is less than...

1 in 50 chance -8.8% -8.1% -11.5% -10.5% -3.0% -3.7% -5.9% -1.0%

1 in 20 chance -5.4% -6.8% -10.5% -6.0% -0.9% -3.6% -4.3% -1.0%

1 in 6 chance -2.6% -4.7% -6.8% -3.6% 0.6% -1.3% -2.5% -0.7%

Worst case short term scenarios: 1-year NOMINAL return is less than

1 in 50 chance -65% -65% -75% -62% -19% -45% -22% 0%

1 in 20 chance -38% -38% -44% -36% -11% -26% -12% 0%

1 in 6 chance -15% -15% -18% -14% -3% -10% -3% 1%

Frequency of years with negative returns

1 year in 3.0 3.0 2.7 2.9 3.9 2.9 4.7 Never



Key assumptions (as at March 2017)

The Australian Equities forecasts assume:

1. Current div idends on ASX All Ordinaries, grossed up for franking credits.

2. EPS growth of 3.2%pa vs forecast inflation of 2.25%pa and real GDP growth of 2.7%pa.

3. PEs mov ing to 16.7, the long-run PE ratio forecast in a low real interest rate env ironment.

The Developed Market Equities forecasts assume:

4. Current FTSE All World Index yield.

5. Currency impact will equal the difference between the Australian 10-year bond rate and that

of a FTSE World Index weighted basket of bonds. This is the return pickup that could be

achieved by fully hedging currency.

6. EPS growth for Developed Markets of 4.8%pa, assuming global inflation of 2.0%pa, and real

GDP growth of 2.5%pa

7. PE ratios at 18.5, reflecting very low real interest rates.

The Emerging Market Equities forecasts assume:

8. Current FTSE All World Emerging Market Index (LOC) yield & PE (Ex Russia)

9. Currency impact of 0.0%pa (less than developed markets because of higher anticipated

inflation in Emerging Markets).

10. EPS growth for EM of 4.6%pa, assuming inflation of 3.5%pa, and real GDP growth of 4.0%pa.

11. PE ratios at 14.6, a discount to developed market PEs.

The Australian REITs forecasts assume:

12. Current yield of ASX A-REIT index.

13. Distribution growth of 2.3%pa which includes the impact of rental growth, development

activ ities and gearing.

14. Yield in 2027 of 5.1%pa, which is farrelly’s estimate of the fair value yield for A-REITs.

The Secure Debt forecasts assume:

15. Yield is the 10 year expected return on TDs, with five-year TDs rolling over at 3.6%pa.

The At Risk Debt forecasts assume:

16. A well diversified portfolio equal to a mix of 50%BBB, 30%BB, and 20%B issues.

17. The pre-default yield pickup is 2.7%pa versus government bonds.

18. The impact of defaults will be equivalent to -1.5%pa.

19. Assumed impact of higher reinvestment rates in 5 years is 0.4%pa.

The Cash forecasts assume:

20. Government bond yields less 0.3%pa.

The Fund of Hedge Funds forecasts assume:

21. Cash plus a premium for fund manager value add (alpha) of 2.3%pa.

For Returns we have assumed:

22. Returns for Australian Equities, DM Equities, EM Equities, A-REITS, Debt and Cash reflect

index returns. No allowance has been made for the impact of active management.

This can be done using the Implementor software.



The long-term outlook for commercial

property

This review looks at the long-term outlook for commercial property, including A-REITs,

global REITs and direct property investment. It uses farrelly’s traditional approach of

looking at yields, the prospect for rental growth, and what the future may hold for

capitalisation rates, the property equivalent of Price Earnings ratios.

A-REITs

A-REITs rose by 15% in the first half of the past year as bond yields fell, before falling 20%

as bond yields turned around. A-REITs then rallied to finish the 12 months to the end of

February almost exactly where they started - another reminder that long-term

forecasting is easier than short-term forecasting.

Growth of distributions

Going forward, growth of distributions is moderating after faster than expected growth

from 2012 to 2015, as shown in Figure 1.

Figure 1: A-REIT distribution growth moderating

The faster than expected growth mainly came from much lower interest costs on debt

and growth in the A-REITs’ wholesale property funds management businesses. Now that

the interest rate cycle appears to have bottomed, what has been a tailwind will

become a modest headwind for distributions over the next decade. Growth from other

activities should continue but more slowly than the growth seen over the past few years

– but probably enough to offset the rising rate headwind.



Over the next decade, A-REIT management will have to grow distributions the old

fashioned way, by increasing rents. In a difficult, but hopefully improving economic

environment, A-REIT management should be able to achieve rental growth around the

rate of inflation, which farrelly’s forecasts to be 2.25% per annum over the next decade.

The impact of depreciation, gearing and cash flow retention on distribution growth

Depreciation is an accounting concept and doesn’t affect short-term cash flow.

However, ultimately it is real and does require injections of real cash, albeit in a lumpy

fashion. We estimate that the long-term impact of depreciation is to reduce distributions

by 1% per annum. That leaves ungeared growth of around 1.25% per annum. Gearing of

30% should lift that ungeared growth from 1.25% to 1.9% per annum.

On average, A-REITs currently retain 10% of net free cash flow - that is, rents less expenses

and interest costs, plus profits from funds management activities. Free cash flow does not

include upward revaluation of properties, profits from sales of properties, or depreciation

- all of which impact profit and loss statements but don’t help us understand how much

cash is available to be distributed.

This retained cash flow of around 0.5% per annum should, when added to capital, boost

growth by 0.5% per annum and partly offset the drag caused by depreciation.

Figure 2 below shows how this all adds up to expected growth of 2.3% per annum.

Valuation ratios - what A-REIT yields should we expect in 2027?

Currently, A-REITs are trading at an average yield of 4.7% per annum, well below historic

yields of around 7.4% per annum when inflation is low. farrelly’s believes this lower yield is

quite appropriate given that A-REITs no longer pay out 100% of free cash flows and,

Figure 2 : Estimate of distribution growth

Factors that drive distribution growth Forecast % pa growth

2017—2027

Rental growth in line with inflation 2.3

Less allowance for depreciation -1.0

= Ungeared growth 1.3

Add impact of 30% gearing 0.6

Add retained earnings 0.5

+Growth from property investments 2.4

Less impact from interest rate increases -0.5

Add impact of management activities +0.5

Distribution growth 2.4

Source: farrelly’s estimates



more importantly, because we expect the low interest rate environment is here to stay.

Lower for longer?

Following the US Federal Reserve’s decision to begin to lift cash rates and the sharp

increases in bond rates around the world, there has been much discussion that the

“lower for longer” theme is dead. farrelly’s believes that this needs to be put into

context.

Figure 3 shows farrelly’s expectation of the old and new “normal” from the context of

Australian bond rates. Yes, rates are up, but they are still unlikely to go back to anything

like pre-GFC levels. While many commentators are suggesting the death of “lower for

longer”, few are suggesting bond rates going back to 5% or 6%. The 2.75% to 3.75%

range suggested is close to the consensus view. As a result, we believe the “lower for

longer” theme is still very much alive, with major implications for long-term valuations.

Figure 3: Australian 10-year Government Bond Yields

If bond yields are lower than in the past, it follows that yields on A-REITs should also be

lower than in the past.

Because A-REITs are expected to return their yield plus growth at around the rate of

inflation, the most appropriate yield to compare with A-REIT yields are real bond yields

(the bond yield above inflation). The best indicator to look at is the yield from inflation-

linked bonds (ILBs), rather nominal bonds. This is because what we get from ILBs is a

smaller than nominal bond yield and capital growth at the rate of inflation, which is

similar to what we get from A-REITs.

On this basis, yields on A-REITs should be the real yield on ILBs plus a risk premium.

Figure 4 (over page) shows that in practice ILB yields do in fact provide a much better

guide to A-REIT yields than do nominal bond yields. Figure 4 shows that the A-REIT yield

premium above ILBs has been much more stable than the nominal premium above



nominal bond yields.

Figure 4: A– REIT yield premia versus nominal and inflation-linked bonds

Pre-GFC, the A-REIT yield premium above ILB yields was around 4.5%. Today’s ILB yields of

1.2% suggests a fair value A-REIT yield of 5.7% - much lower than the pre-GFC normal

7.4% fair value A-REIT yield, but still quite a way from our current yield of 4.7% per annum.

The impact of retained earnings on fair value yield

When comparing current yields with historical yields, we need to recognise that A-REITs

pay out approximately 90% of free cash flow whereas, pre-GFC, they tended to pay out

all (and more) of free cash flow. We expect that A-REITs will continue to pay out around

90% of cash flow going forward, which further reduces the fair value yield from 5.7% per

annum to 5.1% per annum.

Looked at another way, a fair value yield of 5.1% per annum and a 2.3% per annum long

-term growth rate implies fair value returns for A-REITs of 7.4% per annum compared to

our long-term bond rate estimate of 3.3% per annum. A risk premium of around 4.0% per

annum seems reasonable for an asset class that should be a little less risky than equities.

Putting it all together - central forecast, optimistic and pessimistic scenarios

By adding together the current yield, growth in distributions and impact of changing

valuation ratios, we arrive at long-term return forecasts for A-REITs as shown in Figure 5

(over page).

Risks

As is shown in Figure 5, the forecast is one of a range of possible outcomes.



On the pessimistic side, the most likely risk is that of rising capitalisation rates. The

“lower for longer” thesis seems sound, but what if we did get a return to real interest

rates of the order of 3%? In that case, a yield of 6.8% on A-REITs would not be out of

the question and that would reduce returns by 3.7% per annum over the next

decade.

In the shorter term, a major recession could well cause falling rents and substantial

vacancies. In that event, longer-term investors should be fine as long as they stay

through the cycle and are not geared excessively. As always is the case, excessive

gearing remains a major risk. Fortunately, A-REIT capital management generally

appears to be vastly improved since the GFC and, as long as gearing stays at

around 30%, all should be well. Nonetheless, the capacity of A-REIT management to

engage in monumental stupidity should never be ruled out, so we remain vigilant.

The outlook for Global REITs is similar to A-REITs

farrelly’s uses US REITs as a proxy for Global REITs because there is better data

available on US REITs than for other markets and, given that the US makes up two

thirds of the Global REIT index, if we can get US REITs right, we go a long way to

forecasting returns of the broader global index.

Forecast distribution growth

The last four years have seen a staggering 44% growth in US REIT distributions, well in

excess of our normal expectations of 2% to 3% per annum. Like Australia, part of the

growth in distributions has been driven by falling borrowing costs. However, a

bigger driver has been rental growth well in excess of inflation. The latter has been

due to low vacancy levels as a result of demand outstripping supply. This

Figure 5: 10-year A-REIT forecast (2017 to 2027)

Central forecast Pessimistic forecast Optimistic forecast

Current yield 4.7 4.7 4.7

+ growth in distributions 2.3 -3.0 4.0

+ Impact of valuations -0.81 -3.72 0.93

= Forecast return 6.1 -2.0 9.6

Less inflation 2.2 4.0 2.0

= Real return 3.9% -6.0%4 7.6%

Yield in 2027 5.1%1 6.8%2 4.3%3

1. Yield rising from 4.7% to 5.1% in 2027 takes 0.8%pa from returns over 10 yrs. 2. Yield rising from 4.7%

to 6.8% in 2027 takes 3.7%pa from returns over 10 yrs. 3. Yield falling from 4.7% to 4.3% in 2027 adds

0.9%pa to returns over 10 yrs. 4. This is equal to the 1-in-20 real worst case returns shown in Fig 1 on

page 14.



imbalance has mainly been a product of low levels of development activity post-GFC

and slowly increasing demand for commercial property space. Neither of these - falling

interest rates or low vacancy levels - are likely to persist over time.

The US interest rate cycle has turned and we estimate that the impact of a normalisation

of US interest rates over the next decade (where the new normal for cash rates is around

2.5%, not the old normal of 4%) will be to take around 0.7% per annum off US REIT

dividend growth rate.

As for rapidly rising rents and low vacancy levels, we can confidently predict these will

come to an end soon. US property development activity is starting to pick up and will, in

time, bring market conditions back to normal.

US REITs retain close to 20% of free cash flow (compared to A-REITs at 10%) and that

greater capital retention helps them grow a little faster. On the other hand, US REITs

don’t appear to have funds management businesses to supply extra growth.

Nonetheless, we make a small allowance for management value-add as US REIT

managers do appear to be more astute and more likely to focus on shareholder value

than their Australian counterparts.

Fair Value US REIT yields

As is the case with their Australian counterparts, US REITs also appear to trade at a

premium to the inflation-linked bond yield. Figure 7 (over page) shows that US REITs tend

to trade at a level of around 3.5% above US inflation linked bond yields. This is around

0.75% lower than the equivalent A-REIT premium and most likely reflects the higher cash

flow retention rate of US REITs.

Figure 6: Estimate of US REIT distribution growth

Factors that drive distribution growth Forecast % pa growth

2017—2027

Rental growth in line with inflation 2.0

Less allowance for depreciation -1.0

=Ungeared growth 1.0

Add impact of 33% gearing 0.5

Add retained earnings 1.0

+Growth from property investments 2.5

Less impact from interest rate increases -0.7

Add impact of management activities 0.5

Distribution growth 2.3%

Source: farrelly’s estimates



Figure 8: US REIT yield Premium vs. US Inflation-Linked Bonds

With US inflation-linked bond yields now at 0.35%, US REIT yields of 3.8% look at about fair

value. However, farrelly’s expects that real yields on US bonds will head towards 0.7%

over the next decade which suggests fair value US REIT yields of 4.2% per annum in 2027.

Currency

As always, our forecast for currency is the difference between the 10-year bond rates of

the respective countries. The US/Australia bond differential currently stands at 0.6% per

annum, while the US/NZ differential is 1.0% per annum.

Putting it all together - with an estimate of risks - is shown in Figure 9.

Figure 9: 10-year US REIT forecast (2017 to 2027)

Central forecast Pessimistic forecast Optimistic forecast

Current yield 3.9 3.9 3.9

+ growth in distributions 2.3 -3.0 6.0

+ Impact of valuations -0.71 -4.62 1.13

+ Currency hedging prem. 0.6 1.0 0.5

= Forecast return 6.1 -2.7 11.5

Yield in 2027 4.2%1 6.5%2 3.5%3

1. Yield rising from 3.9% to 4.2% in 2027 takes 0.7%pa from returns over 10 yrs. 2. Yield rising from 3.9% to

6.5% in 2027 takes 4.6%pa from returns over 10 yrs. 3. Yield falling from 3.9% to 3.5% in 2027 adds 1.1%pa to

returns over 10 yrs.



Direct Property

This is a hot market. Properties are changing hands at yields that have veteran property

managers shaking their heads and warning of a grossly overheated market. Industry talk

is about peak cycle valuations, and most are expecting a return to the old normal. My

discussions with market participants suggests they don’t buy the “lower for longer” story

(and they may be right, but farrelly’s doubts it) or they haven’t made the connection

between permanently lower bond yields and permanently lower cap rates. The end

result is that farrelly’s believes that most appraised valuations are around 10% to 15%

behind the true market value of direct property.

Figure 10 shows the valuations for A-grade offices in a variety of cities around the world

– and, if anything, Sydney and Auckland look as if they still have room to move. .

Figure 10: Yields on A-grade office property vs real bond yields

Certainly, the A-REIT market seems to think so, with A-REITs trading at a sizable premium

to their direct property valuations. Our expectation is that the A-REIT premium will go

due to increases in underlying valuations rather than falling A-REIT prices.

In the meantime, getting access to the direct property market is tough, particularly if

you prefer to do it with low levels of gearing and fees. There are a number of direct,

unlisted funds available to institutional investors and they have performed well over

recent times, including through the GFC. In fact, farrelly’s cannot recall an ungeared

property investment that has got into trouble, let alone failed. When it comes to

property, excessive gearing does seem to be the root of all evil. However, in the current

environment, it is difficult to see the geared vehicles encountering too many problems

for a year or two. But longer term, who knows?

As far as farrelly’s is aware, there is only one lowly geared, well diversified direct property

fund readily accessible to Australian personal investors. We would like to see more.



Other diversified funds with higher levels of gearing are available. All of the unlisted funds

are likely to be suffering from stale pricing at present - that is, the stated asset backing is

likely to understate the true value of the assets. It’s great for new investors as they get in

at a discount but bad for existing investors whose returns are being diluted.

As always, be very careful with highly geared syndicates. Gearing of 40% to 50%

transforms direct property from a solid, steady source of reasonable returns to a high

return and, more to the point, high risk vehicle vulnerable to shocks. Be careful.



farrelly’s long-term risk assumptions

In formulating the farrelly’s forecasts, a range of different economic scenarios are considered

and, for each, a range of return estimates is produced for the different asset classes. The

scenarios relate to economic outcomes and the Occam’s Razor formula is used to translate

those outcomes into return forecasts. Clearly, it is impossible to be exact about such things

and so the farrelly’s Forecasts are best thought about as the central point of a range of

possible outcomes, not a precise prediction of an outcome.

Prob Description

31% Australian Equities 5 to 10

Developed Mkt Eq. 5 to 9

Cash 1 to 4

Inflation 2 to 3

18% Australian Equities -1 to 4

Developed Mkt Eq. -4 to 0

Cash 1 to 1

Inflation 1 to 2



Cash 1 to 4

Inflation 2 to 3

7% Australian Equities -1 to 4


Cash 1 to 1

Inflation 1 to 2

7% Australian Equities -9 to -3

Developed Mkt Eq. -8 to -4

Cash -1 to 1

Inflation -1 to 1



Cash 7 to 13

Inflation 4 to 8

<1.0% Australian Equities 34 to 66


Cash 27 to 101

Inflation 26 to 101



Cash 4 to 5

Inflation 2 to 3



Cash 4 to 6

Inflation 3 to 4

Governments reject calls for austerity and engage in expansionary spending.

Confidence returns and economic growth picks up world wide. Budgets come back

into balance as taxes increase with earnings. A brief burst of higher inflation is calmed

by moderate monetary and fiscal tightening. Emerging market growth accelerates,

profits grow rapidly, commodity prices recover.

The developed world grows slowly,due to weak demographics and as a response to

governments’ deleveraging and the accompanying fiscal tightening. Corporate profits

grow much the same as usual, inflation and interest rates remain low. Emerging markets

continue strong economic growth. Australia grows somewhat slower than usual. The

resources boom ends. Sometime over the next decade most economies experience a

sharp V shaped recession.

The road map is the Great Depression of the 1930s. Real economic growth is negative,

interest rates very low, earnings collapse and PE ratios fall. This scenario strikes all

economies including emerging markets.

The benchmark is the 1970s – high inflation, very high interest rates, sluggish growth and

low EPS growth. PE ratios are also low. This condition hits the majority of the developed

world.

Range of 10 yr. nominal returns

(%pa), 75% probability

Much of the world experiences hyperinflation such as was seen in Weimar Germany in

the 1930s. Property maintains value but equities and paper-based assets are essentially

wiped out in real terms.

We return to the great moderation – normal interest rates and inflation, normal growth

rates and PE ratios

Hyperinflation

Back to normal

Boom

Recession

Western

recession - not

Australia

Wither Australia

Depression

Stagflation

Base case -

muddle through

Scenario

Most of the developed world, including Australia, experiences little or no growth for the

decade. The best example is Japan from 1990 to 2010. Inflation and interest rates are

low, and profit growth is negative as companies struggle to maintain profit margins. PEs

fall to low levels.

The world divides into two groups: those struggling under high government debt; and,

those with low debt and deficits. For the developed world, the scenario is as per the

Recession scenario above. For Australia and the emerging markets, it looks like the Base

case/muddle through scenario.

The rest of the world follows the Base case/ muddle through scenario while Australia

experiences little or no growth, fall ing EPS, and low PE ratios.


EDITOR’S UPDATE

FORECASTS

farrelly’s Dynamic Asset Allocation Handbook - Mar 2017

Negative gearing is responsible for high property prices

A lot of people seem to believe this, passionately. And, while negative gearing may place

some upward pressure on house prices, the concept that this is a key driver requires us to

regard our fellow humans as completely stupid. So it’s not the worst theory of all time, but

not a great one, either.

Let’s consider Dr Feelgood who earns $500,000 per annum and is looking for a suitable tax

shelter for the $200,000 not needed to support her more than comfortable lifestyle. She is

able to borrow at 5.0% per annum and invests in apartments yielding 3.5% per annum. To

achieve a loss of $200,000 and a consequent tax saving of $100,000 per annum, she will

need to borrow $13 million to buy $16 million worth of property, assuming a 20% deposit.

Along the way, she will pay stamp duty - a tax - of $730,000 or more. So, on this basis, Dr.

Feelgood will take seven and a half years to just break even on tax.

Along the way she has taken on a liability of $13 million. These apartments had better go up

in price!

It is difficult to believe that tax is driving this investment decision. A better explanation

probably goes like this… Dr Feelgood’s friends have all made good money out of investing

in property. If she buys a $1 million apartment which appreciates at the 8% per annum that

she expects, the apartment will double in value in nine years (the rule of 72 again!). After

repaying the $800,000 loan, she will have turned her $200,000 deposit into $1.2 million. Along

the way she will have earned rent of $35,000 per annum and paid interest of $40,000 per

annum. Her $5,000 annual shortfall will be halved, thanks to negative gearing. The end result

is a gain of $1 million and tax refunds of $22,500. Nice! If it works once, she does it again and

again.

If negative gearing was abolished, would she buy another property? Absolutely. This deal

has got to be more about the $1 million gain rather than the $22,500 tax refunds, particularly

if the good doctor recalled the $55,000 she paid in stamp duty on day one. But if prices

stopped appreciating, or if she didn’t expect them to appreciate, it’s hard to see another

property being purchased in a hurry.

In this more realistic view of the world, price appreciation drives negative gearing - it’s not

the other way around. Abolish negative gearing and nothing much happens.

Ironically, if governments of various stripes actually believed that negative gearing drives

property investment, they should be all for it. Given the substantial transfers between the

Federal and state governments, we should look at the total tax take - on a $1milllion

purchase, the combined government take is around $45,000 to $55,000, repaid in $2,500

annual instalments.

As for the notion that removing negative gearing will help housing affordability? It’s nuts and

you can clearly see it’s nuts.

CROCKPOT


EDITOR’S UPDATE

Part 2

Implementation – more than one way to skin a cat 31

Directed Approach – The model allocations

- Explanation 32


Advised Approach – Swim between the flags

- Explanation 34


Bespoke Approach – Plot your own course

- Explanation 36

39

NZ-domiciled investor supplement 40


IMPLEMENTATION

More than one way to skin a cat

Asset allocation is not an exact science. Forecast returns are approximate, risk is multi-

dimensional and difficult to forecast and, most importantly, the efficient frontier is more

like an efficient band or an efficient cloud rather than a line. All of which says that there

are many good portfolios that can be built to achieve a particular objective – in other

words, there is more than one way to skin a cat.

Dynamic asset allocation

The asset allocation approaches described in these pages come under the broad

heading of Dynamic Asset Allocation (DAA). DAA is very different from both Strategic

Asset Allocation (SAA) and Tactical Asset Allocation (TAA). With SAA, asset allocation

changes are made infrequently and are generally small. Under SAA, investors must be

prepared to hold and, worse still, buy assets that are manifestly overpriced. On the other

hand, TAA is generally about making decisions about short-term price moves over a

period that may vary from one to 18 months, which means it is crucially dependent on

correctly timing both the entry and exit.

DAA is all about moving ahead of events, sometimes up to two to three years in advance

of an event occurring – and as such, DAA is not dependent on correctly timing either the

entry or the exit to a position. DAA is essentially a long-term strategy but unlike SAA, it is

not blind to valuation excesses. DAA is all about investing in reasonably priced assets and

most importantly, avoiding investment in overpriced assets.

Different approaches suit different advice models.

farrelly’s offers three different approaches to suit three different types of advisers:

• those who want to create bespoke portfolios to suit their preferences and beliefs

and those of their investors;

• those who believe asset allocation should be left to the experts and who want to

follow a model allocation that is managed proactively; and,

• those who prefer to make an asset allocation change only when it is essential.

Effectively, all this group wants is a quick practical check of their existing asset

allocations to see if a change is needed.

The farrelly’s Dynamic Asset Allocation Handbook caters to all three approaches, with

three distinct sets of guidelines as outlined on the following pages.

Implementation


IMPLEMENTATION

A directed approach – The Model Allocations

This approach will suit those advisers who believe that allocating between asset classes is

something best left to a suitably qualified third party. The Models should be followed

exactly once a suitable level of risk has been selected for the investor. The process farrelly’s

uses to create these Model Allocations is:

1. Create Benchmark Allocations – to give high returns at a given, stable level of volatility.

2. Reduce weights below Benchmark Allocations if assets are fully valued to create Target

Allocations – Even if most risky assets are fully valued or over valued, the Benchmark

Allocations will have a full allocation to those risky assets because the Benchmark

Allocations carry a stable level of risk. In the event that most assets are fully valued or

overvalued as they were in 2007, the overall weights to risky assets will be reduced in the

Target Allocations.

3. Assign zero weights to overvalued assets – In the event an asset becomes overvalued,

that is its expected return is less than that of Term Deposits (TDs), we will assign a zero

weight to that asset class in the Target Allocation.

These three steps result in the Target Allocations, one more is needed to arrive at the

Model Allocations.

4. Move slowly towards the Target Allocations – The first three steps of this process are all

value based and as such, suffer from the curse of all value based approaches; they tend

to buy and sell too early. To overcome the value curse, we stagger changes over time –

generally over 18 months to two years. For example, if the Target Allocation of a particular

asset falls from 16% to 0%, the Model Allocations would generally reduce by about 2% a

quarter until the Model Allocation was 0%. Implicit in this is the idea that when assets

become overvalued, they often go on to become extremely overvalued, and, similarly, if

they become cheap, they often go on to become very, very cheap. As a result, it is

normally a good idea to average in and out of positions over time.

Notes on using the directed approach

1. The Model Allocations may be unsuitable as a long-term buy and hold portfolio – This is

generally where an overpriced asset is in the process of being sold down over time, and

the Model Allocation to that overpriced asset would be too high without a plan for selling

down that asset.

2. Investor portfolios should be rebalanced regularly – If the Model Allocation contains

overpriced assets that are gradually being sold down, it is essential that the selling process

does take place over time. As a result, it is important that those investors following the

Model Allocations review them at least half yearly.

3. New money should follow the Target Allocation rather than the Model Allocation

New cash should be invested in line with the Target Allocation rather than the Model

Allocation because the latter will, from time to time, hold assets that are in the process of

being sold down. It would be counterproductive to buy an overpriced asset one quarter

and sell it down the next. Hence, new money should be invested more in line with the

Target Allocations rather than the Model Allocations.


IMPLEMENTATION

Note: Model Allocations are for use with existing portfolios. Target Allocations are best used for new monies.

Figure 1 : farrelly's Model and Target Allocations - Australian Domiciled Investors - March 2017

Model allocations 1 2 3 4 5

Model Target Model Target Model Target Model Target Model Target

Risky Assets

Australian Equities (%) 8 9 14 16 23 24 32 32 45 46

Developed Market Equities (%) 4 5 8 10 13 16 18 22 24 28

Emerging Market Equities (%) 2 1 3 1 6 2 8 3 11 3

Australian REITs (%) 2 3 4 5 7 8 9 10 8 10

At Risk Debt (%) 6 3 6 3 6 3 6 3 3 2

Fund of Hedge Funds (%) 0 0 0 0 0 0 0 0 0 0

Total Risky Assets (%) 22 21 35 35 55 53 73 70 91 89

Defensive assets

Secure Debt (%) 61 65 56 57 42 44 25 27 6 8

Cash (%) 17 14 9 8 3 3 2 3 3 3

Total Defensive Assets(%) 78 79 65 65 45 47 27 30 9 11

Base case long term returns

10 year total return (%pa pre tax)

10 year total return (%pa,15% tax)

10 year total return (%pa, 46.5% tax)

Yields (%pa pre tax)

Worst case long term scenarios: 10 year REAL returns (%pa) are less than:

1 in 50 chance

1 in 20 chance

1 in 6 chance

Worst case short term scenarios: 1 year NOMINAL total returns (%pa) are worse than

1 in 50 chance

1 in 20 chance

1 in 6 chance


One year in

6.9

6.0

-4.8

-30

5.4

4.7

-2.5

-16

6.1

5.3

3.7

-3.6

-22

4.0

3.4

-0.5

-7

4.7

4.0

-1.2

-10

2.3

3.4

-1.9

0.4

-13

-1

6.5

-0.3

-19

-2

5.2 4.1 3.5 3.2

-1.0

-29

-5 -8 -11

-1.6

-39

-2.2

-52

2.7

3.5

-2.3

3.2

3.7

-3.5

3.8

-4.8

4.3

4.2

-6.7


IMPLEMENTATION

An advised approach - swim between the flags

For advisers who prefer to leave portfolios alone for the most part but want a quick

second opinion on how the portfolios are positioned at any point in time, the Advised

approach is suggested.

Under this approach we set upper and lower ranges for the various asset classes as

shown in Figure 2 on the following page. These ranges are above and below the Model

Allocations which are constructed as described on the previous two pages.

The Advised approach consists of two steps:

1. Compare the investor’s current allocation with the ranges shown in Figure 2. If

outside the range bring that allocation back within the range.

2. Add up the exposure to risky and defensive assets and if inside the ranges then all

is well. If the risky allocation is higher than allowed, reduce the allocation to the

least attractive risky assets and apply that allocation to the defensive assets.

Similarly if the allocation to risky assets is too low, then reduce the exposure to

defensive assets and apply the balance to the most attractive risky assets.

As an administrative process, this is very similar to strategic asset allocation – check the

investor’s current allocation against a maximum and minimum range for each asset

class and, if outside those ranges, rebalance the portfolio back inside the ranges.

However, while administratively similar, the two approaches have very different

outcomes.

The two main differences are, clearly, that the Model Allocation ranges vary over time as

you would expect, but also that the size of the band on either side of the Model

Allocations also varies. Instead of just being plus or minus 5%, farrelly’s believes it is

reasonable to be much more defensive when assets are fully or over priced – it’s just not

sensible to be very aggressive at such times. Similarly, when assets are cheap, the

minimum weight will be close to the Model Allocation weight but there will be much

more flexibility to go overweight.

Notes on using the Advised approach

1. Investor portfolios should ideally be rebalanced either quarterly or half yearly – The

upper limits allow investors to hold overpriced assets because these upper limits will be

reduced over time causing these assets to be sold down over time. Accordingly, it is

essential that the review and selling process does take place at least half yearly.

2. The limits on overall exposure to risky assets should be closely followed – Because the

ranges on the exposures to individual risky assets is quite broad, it would be very easy to

have far too much risk in a portfolio if it were not for the limits on exposures to risky assets

as a whole. This provides much of the discipline in the system and therefore should be

closely followed.


IMPLEMENTATION

Figure 2 : farrelly's Model Allocation Ranges - Australian Domiciled Investors - March 2017

Model ranges 1 2 3 4 5

Min Max Min Max Min Max Min Max Min Max

Risky Assets

Australian Equities (%) 5 - 27 10 - 41 15 - 58 21 - 73 33 - 86

Developed Market Equities (%) 0 - 11 0 - 19 6 - 27 10 - 34 13 - 40

Emerging Market Equities (%) 0 - 5 0 - 5 0 - 6 0 - 8 0 - 11

Australian REITs (%) 0 - 6 0 - 9 0 - 13 0 - 15 0 - 14

At Risk Debt (%) 0 - 6 0 - 6 0 - 6 0 - 6 0 - 5

Fund of Hedge Funds (%) 0 - 5 0 - 5 0 - 5 0 - 5 0 - 5

Total Risky assets (%) 0 - 30 30 - 46 46 - 64 64 - 81 81 - 96

Defensive assets

Secure Debt (%) 48 - 70 37 - 60 25 - 46 13 - 29 0 - 10

Cash (%) 3 - 23 2 - 18 2 - 12 2 - 7 2 - 6

Total Defensive Assets(%) 70 - 100 54 - 70 36 - 54 19 - 36 4 - 19


10 year total return (%pa pre tax) 4.0 4.7 5.4 6.1 6.9

10 year total return (%pa,15% tax) 3.4 4.0 4.7 5.3 6.0

10 year total return (%pa, 46.5% tax) 2.3 2.7 3.2 3.7 4.3

Yields (%pa pre tax) 3.4 3.5 3.7 3.8 4.2


1 in 50 chance -1.9 -2.3 -3.5 -4.8 -6.7

1 in 20 chance -0.5 -1.2 -2.5 -3.6 -4.8

1 in 6 chance 0.4 -0.3 -1.0 -1.6 -2.2


1 in 50 chance -13 -19 -29 -39 -52

1 in 20 chance -7 -10 -16 -22 -30

1 in 6 chance -1 -2 -5 -8 -11


One year in 6.5 5.2 4.1 3.5 3.2


IMPLEMENTATION

A bespoke approach - plot your own course.

This approach best suits those advisers who want to take control of the asset allocation

process but want to do so within a disciplined and logical framework. Long-time farrelly’s

subscribers and those looking though past issues of the Handbook will note that this

approach was the only one offered prior to the September 2009 issue. The principal tools

to use to create bespoke asset allocations are the farrelly’s Benchmark Allocations (see

Figure 3) and the farrelly’s Investment Strategy Implementor.

The role of the farrelly’s Benchmark Allocations

The farrelly’s Benchmark Allocations are designed to indicate what sort of return you

should achieve for taking on a particular level of risk – that is, they are intended to be

used as benchmarks against which to assess the efficiency of investor portfolios.

If a investor portfolio is delivering close to the expected returns of the equivalent

Benchmark Allocation, then the investor portfolio is efficient and doesn’t need to be

changed. But, if the returns of the investor portfolio are well below those of the

equivalent Benchmark Allocation, then the asset allocation of the investor’s portfolio

should be changed – using the farrelly’s Implementor software – until returns are close to

that of the equivalent Benchmark Allocation. Quite often, the investor’s new asset

allocation will be very different from the Benchmark Allocation, but nonetheless it will be

an efficient portfolio.

The Benchmark Allocations are NOT designed to be followed slavishly

Because the Benchmarks Allocations are based on current valuations, they respond

quickly to changes in relative valuations in markets. As a result, they vary by more each

quarter than is sensible to track because, if followed slavishly, they would generate

unnecessary turnover and resulting costs and taxes.

In addition, while the Benchmark Allocations change quickly based on current

valuations, markets often respond quite slowly to valuation imbalances. Once

overvalued, a market can remain so for years and go from being mildly overvalued to

massively overvalued over time. Similarly, when in free fall, a market can move from fair

value, to cheap, to very, very cheap – as was the case in the second half of 2008 and

early in 2009. As a result, the Benchmark Allocations share the curse of all value-based

approaches – they tend to buy too early and sell too early. Hence, better results will

normally be achieved by following the Benchmark Allocations at a lag.

Finally, in order to fulfil their benchmarking role, the Benchmark Allocations maintain a

constant exposure to risk even when risk is unattractively priced. Each portfolios volatility

is aligned to the volatility level of standard industry portfolios. So, Benchmark Allocation 2

will always have the same level of volatility as a typical Capital Stable Fund and

Benchmark Allocation 4 will always have the same level of volatility as a typical

Balanced Fund. This means that even if markets are all highly overvalued, Benchmark

Allocation 4 will have significant exposures to risky assets (equities, property and at risk

debt) in order to match the level of volatility inherent in a typical balanced fund. This is

because the Benchmark Allocations are intended to describe the return to expect for


IMPLEMENTATION

taking on a certain level of volatility. They do not suggest whether it is prudent to take on

that level of risk. That is the role of the adviser in creating the bespoke allocations. In most

respects, the bespoke process should mirror that described in the Model Allocations - but

with much more control in the hands of the adviser.

When building bespoke asset allocations, the following principles should be followed.

Keep transaction costs low

Transaction costs and taxes eat returns. The keys to keeping them low are pretty clear.

Firstly, make as small a change as possible when bringing portfolio expected returns in

line with those of the Benchmark Allocations. To do this, you need to use the farrelly’s

Investment Strategy Implementor software (available to all subscribers on the private

farrelly’s forum). You will find that it is generally possible to find allocations that have

entirely acceptable expected returns but require much less change than implied by

moving all the way to the Benchmark Allocations.

Rebalance infrequently or stagger changes

In order to avoid the value curse, either make infrequent reviews of investor asset

allocations or, when making changes, stagger them over time. We suggest reviewing

bespoke portfolios every one to two years. This way, when assets move into over valued

territory, you will not sell out at the very first moment and miss out on any move to the

very, very over valued status assets can achieve in a bubble. Or, you could choose to

make more frequent changes, but implement them gradually over time. For example, a

decision to increase allocations to international equities vis a vis Australian equities could

be made today, but implemented in six quarterly, or three half-yearly moves over the

next 18 months. How you choose to do it will depend on the nature of your practice and

systems, and the attitudes of your investors.

Vary the risk level as market valuations vary

Because the volatility inherent in the Benchmark Allocations are anchored on typical industry

balanced and capital stable funds, they don’t reduce risk when markets become over

valued. Subscribers using a Bespoke Approach need to make that decision. Generally

speaking, that will mean taking a risk 4 (or balanced) type of investor down to a risk 3 or 2

level gradually over time if a bull market continues unchecked.

Don’t buy Overpriced assets

Holding over priced assets is a real problem if they were bought at over priced levels. It’s

less of an issue if they were bought at fair value. So, one of the keys to building bespoke

portfolios is to simply not buy Overpriced assets. Assets are rated Overpriced when their

expected return falls below the rate of return available on TDs or government bonds. The

Benchmark Allocations don’t help here. Because they always take on market risk, they

may still have significant exposures to Overpriced assets, particularly in environments

where all risky assets are rated Overpriced, as was the case in late 2007.

Dollar cost averaging can help when placing new money

Dollar Cost Averaging (DCA) is simply staggering a purchase of assets over time, typically

when investing new money. Despite a lot of hype surrounding DCA, farrelly’s research

suggests that DCA costs dollars on average. This is because it increases the amount of


IMPLEMENTATION

time spent invested in cash, which tends to be the lowest returning asset in the long-term.

Having said that, here are some guidelines about when it does and sense to use DCA:

1. When markets are Fully Priced according to the farrelly’s Tipping Point Tables (that is,

when they are expected to return less than 2.5% per annum above TDs or

government bonds), DCA doesn’t cost much and may help ease investors’

anxieties. Quite a good idea, in other words. However, make sure that the DCA

program is relatively short-term – no more than six months is our suggestion.

2. When markets are over priced (expected returns are less than TDs or government

bonds) DCA is not a bad idea – but not buying at all is a much, much better one.

Again, just don’t buy over priced assets

3. When markets are at Fair Value (returning 2.5% to 5% per annum above TDs or

government bonds), DCA is very costly and unnecessary. It’s much better to invest

immediately.

4. When markets are cheap and in particular, cheap and falling, then DCA comes into

its own. In this circumstance, it will probably make money as well as relieving anxiety

(critical at these times). Again, keep the program fairly short, ideally a six month

period, but no longer than 12 months.

5. When moving between two risky assets more time can be taken, say 18 months to

two years. The comments above relate to moving from cash to risky assets.


IMPLEMENTATION

Figure 3 : farrelly's Benchmark Portfolios - Australian Domiciled Investors - March 2017

Traditional asset class portfolios Portfolios including alternative assets

1 2 3 4 5 6 7 8 9 10

Risky assets

Australian Equities 9 16 24 32 46 9 16 24 32 46

Developed Market Equities 5 10 16 22 28 5 10 16 22 28

Emerging Market Equities 1 1 2 3 3 1 1 2 3 3

REITs 3 5 8 10 10 3 5 8 10 10

At Risk Debt 3 3 3 3 2 3 3 3 2 2

Fund of Hedge Funds 0 0 0 0 0 3 5 5 5 2

Risky assets 21 35 53 70 89 24 40 58 74 91

Defensive assets

Secure Debt 65 57 44 27 8 65 55 39 23 6

Cash 14 8 3 3 3 11 5 3 3 3

Defensive assets 79 65 47 30 11 76 60 42 26 9

Expected Returns, Yields and Risks for Benchmark Portfolios

10 year total return - pre tax 3.9 4.6 5.3 6.0 6.9 4.0 4.7 5.4 6.1 6.9

10 year total return - 15% tax 3.4 3.9 4.6 5.2 6.0 3.4 4.0 4.7 5.3 6.0

10 year total return - 46.5 tax 2.2 2.6 3.2 3.7 4.3 2.3 2.7 3.2 3.7 4.3

Yields 3.4 3.6 3.8 4.0 4.2 3.4 3.5 3.7 3.8 4.2

Worst case long term scenarios: the chance that 10 year REAL returns are worse than:

1 in 50 chance -1.9 -2.3 -3.5 -4.7 -6.6 -1.9 -2.3 -3.5 -4.8 -6.7

1 in 20 chance -0.5 -1.1 -2.3 -3.6 -4.8 -0.5 -1.2 -2.5 -3.6 -4.8

1 in 6 chance 0.5 -0.1 -0.9 -1.5 -2.2 0.4 -0.3 -1.0 -1.6 -2.2

Worst case scenarios for one year NOMINAL down turns

1 in 50 chance -13 -19 -28 -39 -52 -13 -19 -29 -39 -52

1 in 20 chance -7 -10 -16 -22 -30 -7 -10 -16 -22 -30

1 in 6 chance -1 -3 -5 -8 -11 -1 -2 -5 -8 -11


One year in 6.3 5.1 4.0 3.5 3.2 6.5 5.2 4.1 3.5 3.2

Notes 1. Returns and yields for Australian Equities, Developed Market Equities, Emerging Market Equities, A-REITs, Debt and Cash reflect

index returns. No allowance has been made for the after-fee impact of active management on returns or yields.

2. Long-term worst case scenarios are real (i.e. after Inflation) returns. If subscribers wish to get a sense of nominal worst case

scenarios they should add expected inflation, 2.0%, to these figures.

3. Short-term worst case scenarios are shown in nominal terms, given investors generally think in nominal returns during falling

markets.


IMPLEMENTATION

The forecasts shown below are based upon the Occam’s Razor approach outlined in

the Forecast section. This approach to forecasting has many attractions including accu-

racy, simplicity and transparency. By making available the underlying logic and assump-

tions (Figure 1 below), subscribers are able to quickly understand the rationale for the

forecast and determine the effect of changing the assumptions.

NZ domiciled investor supplement

Figure 1: Expected Returns, Yields and Risks for Asset Classes - NZ Domiciled Investors, March 2017

Australiasian

equities

Developed

Market

Equities

Emerging

Market

Equities

A-REITsSecure

Debt

At Risk

Debt

Fund of

Hedge

Funds

Cash

Yield (pre tax) 4.2% 2.4% 2.8% 4.7% 4.2% 6.0% - 3.3%

+Currency Impact 0.5% 1.6% 0.5% 0.5% - - - -

+ Earnings growth (f) 3.2% 4.8% 4.6% 2.3% 0.0% -1.5% - -

+ Valuation effect -0.6% -1.5% -1.4% -0.8% 0.0% 0.4% - -

Index return 7.3% 7.3% 6.6% 6.6% 4.2% 5.0% 3.3% 3.3%

+ Manager value add 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.3% 0.0%

Total Return (pre tax) 7.3% 7.3% 6.6% 6.6% 4.2% 5.0% 5.6% 3.3%

Total Return (30% tax) 5.8% 5.8% 5.1% 5.1% 2.9% 3.5% 4.1% 2.3%

PE Now 17.8 21.5 16.7

PE 2027 (f) 16.7 18.5 14.6

Yield 2027 (f) 5.1%

Indicative Index All Ords S&P500 FTSE -EM ASX REITs

Index Level 5,850.1 273.5 619.2 1,371.8

Worst case scenarios :10 year REAL total return is less than...

1 in 50 chance 50 -8.8% -8.1% -11.5% -10.5% -3.0% -3.7% -5.9% -1.0%

1 in 20 chance 20 -5.4% -6.8% -10.5% -6.0% -0.9% -3.6% -4.3% -1.0%

1 in 6 chance 6 -2.6% -4.7% -6.8% -3.6% 0.6% -1.3% -2.5% -0.7%

Worst case short term scenarios: 1-year NOMINAL return is less than

1 in 50 chance 50 -65% -65% -75% -62% -19% -45% -22% 0%

1 in 20 chance 20 -38% -38% -44% -36% -11% -26% -12% 0%

1 in 6 chance 6 -15% -15% -18% -14% -3% -10% -3% 1%


1 year in 3.0 3.0 2.7 2.9 3.9 2.9 4.7 Never


IMPLEMENTATION

NZ SUPPLEMENT

Figure 2 : farrelly's Model and Target Allocations - NZ Domiciled Investors - March 2017

Model allocations 1 2 3 4 5

Model Target Model Target Model Target Model Target Model Target

Risky Assets

Australasian Equities 8 7 12 9 17 15 24 20 33 28

Developed Market Equities (%) 11 11 15 16 21 23 27 31 36 39

Emerging Market Equities (%) 2 1 5 2 6 2 7 3 9 4

Australian REITs (%) 5 7 9 13 12 14 13 16 13 18

At Risk Debt (%) 0 0 0 0 0 0 0 0 0 0

Fund of Hedge Funds 3 3 3 4 4 5 3 4 2 3

Total Risky Assets (%) 29 29 43 44 59 59 75 74 92 92

Defensive Assets

Secure Debt 57 60 52 51 37 36 23 22 5 5

Cash 14 11 5 5 4 5 3 4 3 3

Total Defensive Assets(%) 71 71 57 56 41 41 25 26 8 8


10 year total return (%pa pre tax)

10 year total return (%pa, 30% tax)

Yields (%pa pre tax)


1 in 50 chance

1 in 20 chance

1 in 6 chance


1 in 50 chance

1 in 20 chance


One year in

0.0 -0.7 -1.3 -2.0 -2.7

6.1 4.8 4.0 3.5 3.2

-15 -22 -30 -40 -52

-8 -12 -16 -22 -30

-0.9 -1.8 -2.8 -4.0 -5.3

-2.1 -2.8 -4.1 -5.2 -6.9

3.6 4.0 4.4 4.9 5.4

4.0 4.0 3.9 3.7 3.6

4.9 5.4 5.8 6.3 6.8

Notes 1. Returns and yields for Australian Equities, Developed Market Equities, Emerging Market Equities, A-REITs, Debt and Cash reflect

index returns. No allowance has been made for the after-fee impact of active management on returns or yields.

2. Long-term worst case scenarios are real (i.e. after Inflation) returns. If subscribers wish to get a sense of nominal worst case

scenarios they should add expected inflation, 2.0%, to these figures.

3. Short-term worst case scenarios are shown in nominal terms, given investors generally think in nominal returns during falling

markets.


EDITOR’S UPDATE

NZ Domiciled investors - March 2017

These tipping point tables summarise the outcome of the farrelly’s forecasting process

and, in particular, how the forecasts would change as markets change.

NZ SUPPLEMENT

Cheap Fair Value Fully Priced Overpriced

Forecast 5%pa or

more above TDs

Forecast 2.5% to

5.0%pa above TDs

Forecast 0% to

2.5%pa above TDs

Forecast return

lower than TDs

Tipping point tables

All Ords FTSE DM FTSE EM ASX REIT

5850.1 273.5 619.16 1371.8

10250 0.0% 370 3.7% 1000 0.8% 1700 3.6%

9750 0.6% 360 4.0% 950 1.4% 1650 4.0%

9250 1.3% 350 4.3% 900 2.1% 1600 4.4%

8750 2.0% 340 4.7% 850 2.7% 1550 4.9%

8250 2.7% 330 5.0% 800 3.4% 1500 5.3%

7750 3.5% 320 5.4% 775 3.8% 1450 5.8%

7500 3.9% 310 5.8% 750 4.2% 1400 6.3%

7250 4.4% 300 6.2% 725 4.6% u 1375 6.6%

7000 4.8% 290 6.6% 700 5.1% 1350 6.9%

6750 5.3% 280 7.0% 675 5.5% 1325 7.1%

6500 5.8% u 270 7.4% 650 6.0% 1300 7.4%

6250 6.4% 260 7.9% u 625 6.5% 1275 7.7%

6000 6.9% 250 8.4% 600 7.0% 1250 8.0%

u 5750 7.6% 240 8.9% 575 7.6% 1225 8.3%

5500 8.2% 230 9.5% 550 8.2% 1200 8.6%

5250 8.9% 220 10.1% 525 8.8% 1175 9.0%

5000 9.6% 210 10.7% 500 9.5% 1150 9.3%

F'cast

return

Australasian EquitiesDeveloped Market

Equities

Emerging Market

EquitiesA-REITs

F'cast

return

F'cast

return

F'cast

return

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