Myth 1: Emerging markets is a riskier asset class

While emerging markets are certainly not risk-free, the difference between emerging market (EM) and developed market (DM) assets is often overestimated. Recent dynamics are putting that perception to the test. EM economies' credible monetary and fiscal policy of recent years (that is driving positive credit-rating momentum, now the post-COVID default cycle is over) stands in stark contrast to what is going on in some of the world's most 'developed' economies-unpredictable policymaking and unsustainable public finances.

Crucially, this has shifted DM debt into a more volatile regime, blurring the traditional EM/DM divide, according to Grant Webster - co-head of EM sovereign & FX.

For fixed income investors, this matters-at current yields, DM debt would need to make significant capital gains to deliver the risk/return outcomes investors have come to expect. By contrast, in EM debt markets, elevated yields provide most of what is needed to match historical experience. Combine this with a more balanced global growth outlook and easing US dollar strength, and the case for an updated view on EM is even stronger.

Turning to  the corporate sector, with an overall rating of BBB-, the EM credit market is substantially higher in quality than the US high-yield market, to which it is often compared. Yet the compensation for risk is notably higher in EM.

Alan Siow, co-head of emerging market corporate debt notes: This asset class is rife with misconceptions and investors get paid a premium for lending to some very robust companies that have global revenue streams, but just happen to be based in a 'risky' country.

The often-overlooked fundamental strength of EM companies-which typically have relatively low leverage and robust balance sheets-helps to explain why the number of defaults in DM (including some high-profile names), has dwarfed the number seen in EM in the past year or so, according to S&P data.

Similar misconceptions around the EM versus DM risk/reward profile extend to the private debt market, yet EM private debt can provide consistent returns and surprisingly low loss rates.

Lenders in the untapped EM private debt market are in a strong position when negotiating deal terms, from contractual income to investor protections, according to Alper Kilic - head of alternative credit. He states:

Investors can afford to be conservative, for example, by focusing on senior-secured debt with collateral-protected deals and counterparties with conservative balance sheets.

As for the EM equity market, today's investors are buying a more diverse and higher-quality asset class following the significant evolution seen over the past decade. Furthermore, several key drivers of underperformance over the past decade appear to have reversed.

Varun Laijawalla - co-portfolio manager, emerging markets equity, says: First, EM indices underwent some large index rebalancing events, with Chinese equities entering the index at peak or high valuations and then subsequently derating meaningfully. However today, significant share buy-back activity among Chinese companies is having the opposite effect. Secondly, the US dollar headwind looks set to fade or even turn into a tailwind, for EM. The next decade is unlikely to look like the last.

Myth 2: Emerging markets is a quasi-bet on China

While China remains an important part of the EM equity opportunity set-and significant positive shifts have taken place in the Chinese market-for example, reduced prominence of state-owned enterprises-the diversity of the asset class has risen considerably over the past ten years.

The increasingly relevant EM ex-China universe is characterised by very different political backdrops in emerging Asia, Latin America and the Middle East-resilient economies where ease of doing business is typically high.

While Asia remains a major component of the index, with India's weight doubling in the past five years, some of the smaller index constituents also warrant attention. Among the strongest structural stories is the United Arab Emirates (UAE)-this economy's trading agreement with India (among other key trading partners), coupled with attractive equity valuations, make it an efficient way to gain exposure to the India growth story. From a more cyclical perspective, parts of Latin America are particularly interesting, for example, Brazil with its huge pension funds that today have decade-low allocations to equities.

Laijawalla continues: There are robust growth stories in countries across the investment universe, and EM now offers a wide range of opportunities in sectors like technology, manufacturing, and infrastructure, with plenty of companies at the forefront of global developments.

Similarly, today's EM corporate credit universe is truly global-comprised of over 60 countries and home to companies that control global market brands such as Samsung, Volvo and GE Appliances. China now accounts for a mere 6% of the Corporate Emerging Markets Bond Index (CEMBI)-diversification of the asset class means it is not beholden to any single market.

Myth 3: President Trump's tariffs will derail the EM story

Juliana Hansveden, portfolio manager, and EM leader says: The global trade landscape has evolved dramatically in recent years. Exports to the US now represent just 14% of China's total, down over 25% from the early 2010s. This is part of a broader trend for EM economies to trade more with each other as the shift to a multipolar world accelerates-their dependence on exports to the US has been steadily declining since Trump first took office.

While signs of a de-escalation are encouraging, tariffs-wherever they eventually end up- will dent global growth. But they could prove a positive catalyst for EM assets.

Webster says that amid the recent market turmoil, EM assets have held up relatively well as macro risks seem to be skewed towards the US, and a broad erosion of trust in US policy has weakened the dollar, providing a tailwind for emerging markets.

For context, in each of the past two decades, the US dollar has been a dominant driver of EM local currency debt returns. Weakness in EM spot rates against a strong dollar took a particularly heavy toll during the taper-tantrum years (2013/16) and again in the COVID crisis in 2020.

Even if current tariff policy appears contradictory to the goal, it is logical that the US administration would like the dollar to weaken. A strong dollar has eroded the competitiveness of the US economy. China's economy now exceeds the US (on a Purchasing Power Parity GDP basis), and progress in the country's tech sector is shifting the balance of technological leadership-in some cases posing a direct challenge to the US.

Crucially for active investors, within the EM asset class, the impact of tariffs and slower global growth will vary by country.

Hansveden continued: Some EMs may benefit from China's reduced US market share, while others like emerging Asia and Mexico, are well placed to implement supportive policy responses. In this new world order, countries that diversify their economies, forge strong regional alliances, and skilfully navigate between different global powers are likely to emerge as long-term winners. Far from being a threat, today's geopolitical friction could serve as a catalyst for long-term EM outperformance.

Myth 4: Innovation only happens in the US

Technology is transforming the EM equity landscape. As these new-economy companies innovate, disrupt and grow, they are crowding out the old-economy companies that are more capital-intensive, less well-run, and less focused on profitability.

Siow continued: AI (artificial intelligence) is accelerating this shift. While US firms own the intellectual property, the infrastructure which it will run on-data networks, data centres, computers and smartphones-will be largely manufactured in Asia. Asia is emerging as the world's AI factory, driving a widening range of technology sub-sectors.

At the start of 2025, DeepSeek, a China-made AI model, shook the tech world, bringing a new AI chatbot to market at a fraction of the price of other key global players. If DeepSeek's efficiency gains are verified, it is likely to lead to lower investment requirements and a flattening of technology barriers at a global level. Both will implicitly benefit energy-poor regions and relative tech laggards, thereby undermining a pillar of US exceptionalism.

Laijawalla said: India has also emerged as a new superpower in recent years and has become an innovation centre, with a boom in investable tech and internet companies. The COVID-19 pandemic was a catalyst, accelerating trends that have been particularly beneficial to India's corporate sector.

Innovation also extends to sustainability. In the field of transition finance, for example, a data centre operator in India is providing high-performance computer services across Asia (through a partnership with NVIDIA), using a proprietary immersion cooling system that reduces energy and CO2 output by up to 50% and uses a fraction of the floor space versus traditional air-cooled data centres.

Matt Christ, portfolio manager - emerging market transition debt, observes that "EM innovation intersects with commercial returns and sustainability goals, especially as EMs develop the infrastructure underpinning global AI and digital economies".

Myth 5: Corporate governance and sustainable opportunities do not exist in emerging markets

Corporate governance trends in EM in recent years are encouraging-for instance, in levels of share buybacks and dividend payouts in China. More broadly, the macroeconomic foundations underpinning EM equity markets is another area of considerable strengthening in recent years. Behind this is a steady improvement in the standard of stewardship by governments in key economies across the EM universe, resulting in structurally lower economic volatility and lower average inflation rates.

Hansveden goes on: Turning to sustainable investment opportunities, financial inclusion, healthcare access, digitisation and infrastructure development are just some of the structural shifts taking place across EM economies - investors can seek to tap into the opportunities these present. With a large share of the world's unbanked population residing in EMs and so too the majority of the clean energy investment gap, this is a sizeable opportunity set.

Emerging markets are central to the global energy transition. EMs are rich with opportunities, either through financing the energy transition of companies with credible net-zero targets and policies in place, or investing in renewable energy, where EM corporates play an increasingly dominant role.

This theme is also relevant for investors seeking a sustainable tilt in their portfolios-EMs offer fertile ground for sustainable investment, from green bonds to transition finance, that support long-term global climate goals while also delivering long-term value.

This is largely due to conservative management styles, sector exclusions, and structural biases that have limited their returns-leading many investors to rethink their role in credit portfolios.

In this article, we take a deep dive into the convertibles market, looking at the different types of convertibles and their use in credit portfolios-and the potential reasons why convertibles, and particularly the active managers that use them, have underperformed expectations.

What are convertible bonds?
Convertible bonds are a type of debt issued by companies as an alternate form of financing to the typical issuance of debt or equity, with characteristics somewhere in between the two.

A convertible bond is structured as a fixed rate bond, with a call option embedded within, allowing the bondholder to convert the security into equity of the issuing company, once the company's stock price moves above a certain threshold (known as the option's strike price).

Convertible bonds may be either mandatory or non-mandatory; that is conversion to stock is forced or optional once the equity price reaches the strike price.

To compensate for this added benefit within the bond, the fixed yield of the bond component is typically lower than that of an otherwise comparable fixed rate bond issued by the same or similar entity.

This is clearly beneficial for those able to issue convertible bonds, as the lower coupon to the investor means a lower cost of capital for the issuer.

Credit accounted for 52% of issuances for 2024, equally split between financials, utilities, and industrials. Other sectors of note were auto, which accounted for 7%, and real estate, whose 6.5% of issuance indicates signs of recovery after a muted 2023 due to weaker fundamentals.

Sovereigns enjoyed strong momentum, accounting for 28% of issuances, and reflecting the strong dynamic among European countries-most of which are already issuing green bonds-but also new issuers such as Australia.

The euro remained the key driver of growth with 60% of issuances while emerging markets (EM) declined from 10.4% to 6.5%. Of particular significance is the decline in issuances from US issuers which was only 8.5%-half of what it used to be-and led a sharp decline in USD-denominated issuances-14% versus 20% in 2024.

The shifting economics of AI development and deployment

On the 20th of January, a little-known Chinese AI start-up, DeepSeek, released a free and open-source generative AI chatbot able to rival the US industry giants. The release went unnoticed until a few days later when more details about its large language model (LLM) became widespread.

LLMs are general-purpose models trained to understand human language and perform tasks such as generating text or answering questions. These serve as the basis for various AI applications, including, but not limited to chatbots, search engines, and document summarisation. Developing a state-of-the-art LLM system typically requires significant capital expenditures and ongoing operational costs. As a result, this field is dominated by a handful of tech giants-such as Alphabet, Amazon, Meta, and Microsoft-investing billions in data centre infrastructure, training proprietary AI models, and reinforcing their industry leadership.

The rise of DeepSeek

Against this backdrop, the rise of DeepSeek may be viewed as a black swan event, or at the very least a watershed moment in the current AI landscape. Indeed, compared to the previous LLMs, DeepSeek claimed to build its application at a small fraction of the cost (measured in millions of dollars rather than billions) compared to other leading LLMs, using far less computation power and fewer chips. Although questions still arise on the validity of these claims, the achievement has cast doubts on several economic and technical assumptions taken for granted when developing AI models: massive scale, billions of dollars in capital expenditures, substantial power requirements, and costly NVIDIA graphics processing units (GPUs). As a result, these requirements may no longer be essential, lowering entry barriers for new competitors and signalling a profound shift in the economics driving future AI advancements.

DeepSeek innovation could represent a significant milestone of the current AI paradigm. However, it should not be seen in isolation but as part of a broader and expanding ecosystem of businesses competing to push the technology frontier further and gain market shares. Indeed, in the weeks following DeepSeek's announcement, several companies, including OpenAI, ByteDance, Alibaba, Mistral, and Moonshot, released new versions of their own AI models with either more complex reasoning capabilities, enhanced performance, improved functionalities, or lower customer fees. This suggests the AI race is just in its infancy, and its rapid evolution will likely continue at a breakneck speed.

Of course, it has not all been painful, though we sometimes find ourselves pining for the increasingly distant 2022, when listed infrastructure's inflation-protecting characteristics fully met the moment and GLI outperformed global equities by 14% . We also felt good about how the first nine months of 2024 evolved, with various central banks embarking on rate cuts and as US utility and energy investors participated in the wave of generative AI enthusiasm.

Although the most recent asset class performance has been frustrating, our team reached an important investment performance milestone last year-our five-year track record-and (mostly!) had fun doing it.

In 2025, the long-term risk and return profile of GLI continues to support its inclusion in portfolios.

Specific to 2025, we offer five reasons to be a buyer of the asset class:

1. Today's valuations offer an attractive entry point for long-term investors
2. We expect fundamentals will continue to be strong
3. A lot was priced into markets post-US election, and some near-term reversion could benefit pockets of GLI
4. It may be a good time to complete your private infrastructure allocation with GLI
5. Diversifying your equity exposure continues to make sense

What is AI?

Before we can delve into the topic of responsible AI, it's important to distinguish Gen AI from human intelligence and Artificial General Intelligence (AGI), which is when models become as or more intelligent than humans. Gen AI has the capability to generate new and original content with what are known as 'transformer models' - a type of AI model that generates human-like text by analysing patterns in large amounts of data. These models, which use an ever-increasing range of parameters (Open AI's Chat GPT-4 has over a trillion), help algorithms learn, react, create and predict using historic data and interactions.

As investors look to 2025, a number of key themes-from a second Trump administration to record US corporate profitability to widespread adoption of groundbreaking scientific advances-are expected to shape macro and market conditions. Under a second Trump administration, investors expect that the United States will undergo several major policy shifts around trade, tariffs and immigration, to name a few. These shifts will not only have major ramifications for the local macro and market environment but also on the rest of the world.

A key feature of the US equity market's strength has been the recent profit margin dynamics. Margins are near historical highs and there is no sign of a major profit margin correction on the horizon. Could corporate America be experiencing a profit margin structural shift? Time will tell, but sometimes too much of a good thing can be bad for markets. One risk to watch is the economy and markets running so hot that a no-landing scenario arises in the US. If that scenario were to take hold, there is a possibility that inflation would resurface as a major macro risk, with broad implications for the policy outlook of the US Federal Reserve.

While a no-landing outcome would mean that the US has moved to a higher growth trajectory, it would also imply that market rates may stay higher for longer. Meanwhile, the challenges facing China appear to be very different in nature. China's structural headwinds remain considerable. These include the highly distressed property sector, substantial local government debt burden, elevated deflation risks, systemic overcapacity in the industrial sector and adverse demographics. Aware of these challenges, the Chinese government is trying to revive the economy through a broad policy package, but we remain sceptical that these issues will be effectively addressed.

Looking at the global backdrop, we are standing ahead of the great bifurcation, with growth and monetary policies showing increasing signs of divergence, a propitious environment for active global asset managers. Finally, a key sectoral theme we are watching is the advancement of game-changing lifestyle pharmaceuticals (GLP-1s) that may produce a transformational impact extending beyond healthcare.

Australia's hybrid bond market rarely makes headlines, but in recent weeks it has been firmly back in the spotlight. The Australian Prudential Regulation Authority (APRA) recently revealed plans to phase out Australian banks' use of additional tier one (AT1) capital [which can be considered riskier, thereby enhancing the overall stability of the banking system].

The announcement came on the heels of a surge in interest in corporate hybrids sparked by the successful raising for Australian Securities Exchange (ASX) listed mall operator Scentre Group. Yarra's outlook for Australia's hybrid bond market - of which bank AT1 hybrids make up around $41 billion - considers these latest proposed regulatory changes while focusing on the future potential for hybrids in funding corporate Australia's energy transition ambitions.

Investors and issuers alike are now navigating a market partly in transition. More immediately it seems that in the wake of APRA's announcement, some are betting that a shrinking pool of Australian bank hybrids will drive up demand, pushing prices higher and yields lower across Australia's big four banks. Since last month's announcement, spreads for Tier 1 securities have contracted ~16bps-so retail investors are eager to bid up assets and get a larger slice of a shrinking pool.

While uncertainty prevails in hybrid bank issuance for now, and short-term opportunities may arise, over the longer-term a broader set of dynamics is emerging for hybrids, particularly in sectors like energy and infrastructure.

In partnership with CoreData, we researched advisers' use of alternative assets, and the findings show that alternatives are more than just an investment strategy. Implemented appropriately, with the right due diligence, investing in alternatives also offers the opportunity to enhance client engagement and create the collaborative advice/client partnership HNW investors are increasingly seeking.

While perceived barriers and challenges are often curbing advisers from having a conversation on alternatives with their clients-with the right information, client education support and platform partner, these hurdles can be overcome. This can free advisers to craft a tailored portfolio aligned with the investors' unique goals and risk profiles and implement a niche investment proposition that propels their advisory service.

The research shows that HNW investors continue to be the largest market for alternative assets, with 17% of this segment investing in this asset class, and almost two-thirds of advisers dealing frequently with HNW investors report recommending alternatives to their HNW investors in the last year.

With investment opportunities under the alternative investment banner increasing exponentially over the last few years, the asset class is becoming more accessible and of greater interest to the wider affluent investor segment.

According to PwC, alternative asset classes will more than double in size, reaching $21.1 trillion by 2025 and are set to account for 15% of total global AUM.

It is a trend we have seen play out on the Praemium platform with a 23% uplift in alternative asset funds under administration during financial year 2023 and an 11% uplift in alternative asset FUA in financial year 2024.

In a little over a decade, Australian private debt has developed into an accepted asset class which plays an important role in the investment strategies used by both institutional and individual investors.

The evolution of the local market is part of a worldwide trend that continues to gain momentum and will likely result in more people holding private debt alongside traditional equity and fixed income assets.

Private debt funds raise money from investors and lend it directly to medium-to-large-sized companies in a similar manner to banks. The global financial crisis (GFC) and the economic fallout from the COVID-19 pandemic sparked the growth of the private debt market in two ways. First, following the GFC, banks were forced to become more conservative in their lending and to hold increased capital against certain types of loan assets. This restricted the availability of business credit and forced borrowers to search for alternatives.

And second, in response to the economic fallout from the COVID-19 pandemic, central banks slashed interest rates to near zero in a bid to stimulate growth, forcing investors to look beyond traditional investments such as bonds or term deposits to generate income.

Private debt largely filled these needs, and the global market has since grown rapidly, with an increasing number of fund managers offering access to it.

Most private debt managers have a focus on providing loans to medium-to-large-sized companies or financing projects in areas such as commercial real estate (CRE) and infrastructure.

Australia's corporate loan markets can be split broadly into five sectors. At various times, each of these segments may offer better risk-adjusted returns and therefore better lending opportunities than others:

• Corporate loans
• Leveraged and acquisition loans
• Project and infrastructure loans
• CRE loans
• Structured finance

The Year of the Dragon is supposed to bring good luck, and 2024 certainly seems to have started this way. Following healthy market performance in 2023, a soft landing in the United States and elsewhere is now the consensus view. While risk markets have priced in this scenario, we see three tail risks that could derail this soft landing scenario. In this article we share our thoughts on how our global fixed income strategies are positioning exposures given these tail risks.

Tail risk 1: Geopolitics

Geopolitics always presents a risk, but the large number of elections, ongoing wars and evolving macro policies make this year particularly challenging.

As we move through the year, the US presidential election will be a major focus. Whoever wins, there will be broad implications for security risks, global trade and fiscal policy. If Donald Trump wins, the long-term path of the US dollar should be the focus, especially if there are questions around the rule of law or the institutional strength of the United States. In addition, there could be significant adverse outcomes for certain sectors or asset classes, and in particular for emerging markets.

The path of US fiscal policy is also high on our radar. Usually in election years, the incumbent president loosens fiscal policy. This time the fiscal deficit is quite stretched already, and we do not expect a material change in the overall fiscal deficit this year. Regardless of who wins, we expect a sizable deficit to persist, but the fiscal contours would be different as Democrats would likely continue to focus on spending while Republicans would likely focus on tax cuts. With that in mind, we will continue to discuss debt sustainability issues in the US and the path of term premia in the yield curve. Outside the US, European Parliament and Commission elections in June could introduce fiscal or policy friction, which again may impact currencies and local bond markets.

Discussing the market impact further, the ongoing wars in Ukraine and the Middle East bring a renewed focus on energy and commodities. Europe is better prepared today for energy shortages than when the Ukraine conflict started. However, the energy market could still unravel, particularly if troubles escalate in the Middle East. We are already seeing impacts on supply chains and the cost of commodities, so understanding how the price of oil impacts risk in portfolios is important. In terms of tail risks, potential conflagrations of tensions in other geopolitical hotspots like North Korea and Taiwan bear watching.

The final geopolitical element is the development of macro policies and the economic environment in China and Japan but in each for different reasons. With China, we worry that the country could end up exporting deflation if its current stimulus program does not yield sufficient growth, which would be a negative for Germany and emerging markets as they exhibit the high levels of trade with China. With Japan, the tail risk would be a disorderly move away from its negative interest rate policy. A strong, sharp appreciation in the yen could lead to an unwind of foreign assets by Japanese investors. This profitable carry trade has existed for many years, and its unwind could potentially trigger higher yields in global core rate markets and bear steepening of yield curves.

The combined effects of spiking inflation and rising interest rates has ended the era of cheap debt. Increasing finance costs for borrowers has weighed on earnings and investment returns. This has been acutely felt in more traditional (core) office real estate where revenue is built around structured rental flows, leaving little room to pass through higher costs.

The increase in cash rates has pushed government bond yields higher creating investor concern around a corresponding expansion in capitalisation rates for core real estate and a potential decline in asset values

After experiencing a jolting decline in value in 2022 as investors de-risked their positions, Australian listed real estate securities stabilised in 2023. The ASX 300 Australian Real Estate Investment Trust (A-REIT) index has outperformed the ASX 300 this year, although performance has been concentrated in a few stocks. The questions around capitalisation rates and market valuations continues to dominate the sector.

Overshadowing this has been talk of a global slowdown, stemming from central bankers committing to a strategy of rate hikes to curb inflation, sending the asset class into a halt.

Fuelled by the pause in capital invested in core real estate and supported by compelling demographic and structural changes supporting improving demand drivers, 'alternative' (operational) real estate is set to broaden its investment footprint.

According to JLL Research Australia's report Alternative Investments Outlook 2023, the market in Australia is estimated to be valued at more than ~$235 billion, but what is alternative real estate and what are the key factors driving increasing investor demand?

In its absolute simplest definition, alpha is just the return of a portfolio over its benchmark: α = portfolio return - benchmark return

However, being managers who emphasise 'factor investing', we do not consider this a true

reflection of manager outperformance. We will get into why that is later, for now, let's just term the definition set out above as 'naïve alpha'.

Given that most advisers would hear the term alpha in relation to managed funds, let's focus on that particular investment product and consider the dangers of just paying attention to, or chasing naïve alpha.

Equity market performance surprised many investors in 2023, ending the year considerably higher than anticipated, although not without periods of considerable drama. One such instance occurred in March when a regional banking crisis prompted the Federal Reserve (Fed) to establish a bank funding program that allowed it to address banks' liquidity issues. It was a precise, and ultimately effective, response that allowed the central bank to contain the issue while also continuing to keep rates elevated. This allowed the bank to address the crisis while continuing its battle against inflation, one which appears to be moving in the Fed's favour.

Within capital markets, global equities, as measured by the MSCI AC Word Index, rose more than 20% while core fixed income, as measured by the Bloomberg Barclays Global Aggregate Index, broke a two-year losing streak, ending in positive territory. A wave of investor enthusiasm, partially driven by the promise of artificial intelligence (AI), swept over equity markets through to mid-year, driven by the Magnificent Seven, [Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla], a collection of mammoth US technology companies whose earnings power and balance sheet stability paint a picture of invincibility. However, history tells us that such subsets of stocks seldom travel in lockstep over long periods of time, highlighting the importance of analysing each of these companies on their individual merits.

This will be particularly important as we move into a more changing investment environment, one with the potential for greater geopolitical instability, elevated sovereign debt levels, higher borrowing costs and shifting global supply chains.

Markets have been hostile this year. There has been a material increase in the cost of capital on the back of the rapid rise in interest rates globally. We have also seen an extreme narrowness of the market. Investors have grown accustomed to the fact that technology has become a dominant driver. A handful of companies have provided outsized returns this year, largely generated by the Magnificent 7 - Apple, Microsoft, Alphabet (Google), Tesla, Amazon, Nvidia and Meta (Facebook). A lot has been written about these goliaths and their link to the hype surrounding artificial intelligence and the way in which it will change everything.

While the market is up 10% this year, nearly two-thirds of that total return is directly attributable to these seven stocks, up on average by 84%. Owning anything outside of these names, therefore, has been a challenge for many portfolios.

Artificial intelligence or artificial valuation?

Most of the top performers' returns have come from a rerating, with the result that investors are paying more for the prospective expectations of returns rather than the actual earnings growth they have delivered, even though the earnings for those stocks are up an impressive 31% on average. These shares have, therefore, become more expensive in the context of the broader market. Simply measured on a forward price/earnings basis, they are 40% more expensive than they were at the start of the year. If that is the case, you must be confident that the growth is going to come through. However, it is hard to see how trillion dollar-plus market cap companies will be able to compound at the same rates of return they have done historically. How much revenue are they going to have to continue to generate when the starting point is more than $100 billion dollars a year?

Before we dive into the challenges, why is meaningful comparison and measurement important in this space? The Australian Prudential Regulation Authority Choice Heatmap and MySuper Heatmap have brought into focus that the regulator expects trustees to be accountable for long-term net returns delivered for a particular risk profile and that fees should be scrutinized. So, advisors must oversee the net return outcomes of clients' portfolios and also monitor whether there are better value products available. Both are central to discharging their fiduciary duty. To do that, confidently comparing a client portfolio with an appropriate reference benchmark and comparing fees and costs is required. But is this easier said than done?

Different comparison points for managed accounts

Undoubtedly, personalisation can make comparison tricky. An individual's starting point and ongoing investment decisions affect return outcomes regardless of whether you're invested in a managed portfolio or a managed fund. But in a managed account, the platform's trading and rebalancing rules, the client's portfolio size, and their individual preferences, by way of exclusions, can also affect performance outcomes. How best to compare?

What's more, after 2022's poor returns for nearly all risk assets and the breakdown of the traditional 60/40-equities/bonds-portfolio, historical correlations have largely been restored. Bonds once again can serve as a valuable hedge to equities and other risk assets. This is especially important as they offer compelling income in both nominal and real terms, which is well above recent equity yields (S&P dividend yield of 1.6%). In other words, one of the most important qualities of fixed income-the diversification benefit-appears to be functioning again. Finally, we believe current yields may be a good indicator of what investors can earn over time.

1. Attractive valuations: Most favourable for investors in last 15 years
Bond valuations are attractive-with investment-grade credit currently yielding around 6%, investors can beat cash rates and don't need to reach for yield in riskier sectors any longer. Bond yields are also as attractive as they have been since the global financial crisis, according to Bloomberg. But one benefit in the aftermath of 2022's rough patch is that yields and valuations have been restored-offering new opportunities for carry.

Platform fees typically comprise a headline administration fee, expressed as a percentage of assets under custody, and could have an additional fixed dollar account fee. Note that different platforms will offer their own level at which administration fees are capped and should be considered separately. In analysing and comparing fees an often neglected, yet important consideration, is the ancillary fees related to regulatory expense recovery, superannuation administration costs, or trading costs. The actual cost to the investor can be markedly different between platforms depending on the investment option selected and how the investment manager and client interact with the platform. If a complete analysis is not conducted, the full cost implications to an investor are not considered and this could challenge the adviser's ability to prove best interest was attained.

Evaluating the cost of running your investment philosophy on differing platforms should account for all costs, including:

• Platform administration and account-keeping fees
• Manager MER variances and governance fees
• Impact of trading costs.

We have undertaken an analysis of these fees to demonstrate how on the face of it cost can seem straightforward but when factoring in all costs, different outcomes may be delivered for a client's portfolio.

This is first evident in the robust investment strategies that mul­ti-asset funds, in particular, are able to deliver to clients. In a world where even Future Fund chief executive Ralph Arndt believes set-and-forget strategies based on beta are insufficient to guarantee performance, it is almost undeniable that the portfolio construction skills of multi-asset managers should be considered for inclusion in every adviser's arsenal.

Arndt told a public forum in April 2023 that rapid change in the global environment means that the role of alpha in portfolio con­struction is more important than ever-and that the nation's sover­eign wealth fund was compelled to evolve its strategy in response.

Multi-asset managed accounts offer a similar opportunity to fi­nancial advisers and their clients. The best providers, for example, proved their mettle in early 2022 by adjusting fixed income port­folios to counteract the impending quick-fire program of interest rate hikes implemented by central banks. By increasing their ex­posure to short maturities and global credit securities, these pro­viders were able to limit losses in a period in which bonds bucked conventional wisdom by underperforming at the exact same time as equity markets.

Well-resourced managed fund providers with experienced re­search teams also benefited from adding an allocation to the fast-growing private credit sector that added extra ballast to portfolios. The very nature of private assets means that evaluating each poten­tial investment, let alone constructing an appropriately diversified portfolio, requires a particular level of insight and focus to manage the inherent liquidity risk in this relatively new asset class.

These are just two examples of the adjustments that managed account providers could make in the turbulent market conditions of the 2020s.

Fortunately, the Separately Managed Account (SMA) offers a way to circumvent the large amount of administrative rigmarole that comes with providing effective and timely advice. This all-encompassing approach to investment portfolio management provides a streamlined client solution, empowering advisers to efficiently handle their business while maintaining a strong focus on investment outcomes.

Despite their undeniable benefits, many advisers have been hesitant to embrace SMAs, fearing cookie-cutter solutions and client rejection of the approach. In this article, we aim to debunk common misconceptions surrounding SMAs and shed light on some of the often-unconsidered benefits with the structure.

Firstly, we provide historical context of how current bond market signalling is consistent with previous periods, where it was prudent to be underweight growth assets and to incorporate high quality bonds within one's portfolio.

We then showcase bond market returns across these periods to highlight how bonds can outperform on a relative basis and protect capital once these bond market signals are activated. We show the range of returns that are possible and that should be expected from bonds through these periods.

Additionally, we conduct a simple analysis where we speculate on bond index returns based on carry, changes in interest rates, current levels of bond market convexity and yield curve twist.

Background and historical context

A yield curve is a line graph that plots the yields or interest rates of bonds with different maturities. The yield curve shows the relationship between the bond yield and the bond's time to maturity.

The last 120 years provides robust data on how the yield curve can forewarn of impending stress in the economy and financial markets. The exact reasons for the robustness of this relationship can differ in every scenario.

Inversion of the yield curve, where longer term bond yields are lower than short term bond yields, may be a product of the intentional intervention by monetary authorities in order to slow the economy, mainly from the perceived threat of inflation.

It may also be a function of market participants' expectations of lower growth and economic activity. In such a scenario these participants may flock to higher quality and 'safe' assets such as bonds, pushing down the longer-term rates and causing the inversion.

Whilst yield curve inversion can be attributed to either of the above two hypotheses, they may not be the only cause.

ESG trends, challenges and misconceptions

Demand for responsible investments is growing as financial advice clients search for ways to invest for impact and leave a positive legacy for future generations.

Australian trends

Responsible investing is no longer a niche investment concept sought out by a select group of financial advice clients. The pandemic, natural disasters, climate change and a growing awareness of our world and environment have prompted clients to pay more attention to how and where their money is invested.

According to research from the Responsible Investment Association Australasia (RIAA), 83% of Australians expect their super to be invested responsibly and ethically, and 80% expect their savings to have a positive impact on the world. In addition, 64% of Australians expect their financial adviser to be knowledgeable about responsible investment options. This has increased from 54% in 2020 and is now the number one expectation that Australians place on financial advisers - even prioritised over investment returns.

As a result of this growing demand, companies and investment managers are responding to bottom-up pressure to report on their sustainability metrics, and top-down pressure from regulatory bodies such as the ASX, ASIC and APRA to ensure products are labelling themselves truthfully as the pool of responsible investments continues to grow. The increased focus on sustainability is having a positive impact on corporations, prompting them to improve their business operations to compare favourably to their peers and attract capital from institutional and retail investors.

The ride was volatile but international fixed interest lost 12.3% last year while Australian fixed interest lost 9.7%. Meanwhile, global equities lost 12.5% and Australian equities lost 1.1%.

The performance of bonds and equities was highly correlated - they both went down at the same time.

Let's start with a basic question: What exactly is 'portfolio construction'?

Portfolio construction

Portfolio construction is the process of combining different asset classes and individual investments in a way that appropriately balances risk and return, with the objective of achieving your financial goals over a defined time horizon.

Part of the process is determining your allocation to growth vs defensive assets. This is likely to include stable investments like cash, more volatile investments like shares, and other asset classes in between.

Diversification-also known as not putting all your eggs in one basket-is probably a term you have heard before.  Given the volatility we have seen in asset markets throughout the past 12 months, diversification is as important as ever. Fortunately, there are free lunches in finance and diversification is one of them.

Yet there is good reason for the industry to look forward with a spring in its step. Despite slowing growth, there is some hope that inflationary pressures may be starting to ease, while Australia's distinctive geography and economy shield it from some of the coldest economic headwinds. These factors may also create new opportunities, with China's re-opening being a particularly strong one. Already this year we have seen its ban on importing Australian coal lifted, and the first trade talks between the two nations since 2019, after a period in which products from iron ore to lobster and wine have been off the menu.

Everyone wishes the economy was better and inflation lower, but it's also acknowledged that the situation could be a lot worse. The general sentiment appears to be that Australia will not fare too badly compared to many other economies: unemployment remains low, household savings are still above pre-pandemic levels, and industry confidence is solid: 59% of business leaders are optimistic about the Australian economy in 2023 and 78% about the performance of their own company.

There are still challenges ahead - notably the financial impact on homeowners exiting fixed-term mortgages - but if this is indeed the year in which inflation peaks and one of the country's most important trading relationships stabilises, Australia's fund managers can expect to be operating on a firmer macro-economic footing after a period of volatility. As the economy hopefully steadies, the question then becomes how the industry itself can evolve and return to growth.

It is one thing for algorithms and machines to capture and analyse data. It is another for nuanced decisions and complex problems to be handled without human intervention. For finance businesses handling large amounts of critical data, automation alone may not deliver the level of assurance or service clients have come to expect.

This is where human-centred automation comes in.

However, when comparing an adviser perception of these benefits against the length of time they have used managed portfolios, an interesting trend begins to emerge- the longer an advice business uses managed portfolios, the higher their conviction in the client benefits they offer.

What are the main differences?

Separately Managed Accounts

From a compliance perspective and generally speaking, an SMA is a Managed Investment Scheme which makes it an investment product requiring a Product Disclosure Statement to be issued. SMAs are usually found as part of a private client set-up or as a menu selection on regulated platforms.

The platform acts as the Responsible Entity [that is, the entity that acts as manager/trustee of a registered managed investment scheme], and is responsible for the investment manager adhering to the investment mandate of the model portfolios. The adviser can simply recommend an SMA as they would any other type of investment product, as long as their Australian Financial Services (AFS) Licence gives them authority to deal with Managed Investment Schemes.

Managed Discretionary Accounts

MDAs are explained by the Australian Securities and Investments Commission (ASIC) as being both a 'facility' for making a financial investment and a Managed Investment Scheme. As the facility component creates an element of advice, MDAs have relief from requiring a Product Disclosure Statement or a Responsible Entity.

So, generally speaking, an SMA is a product and an MDA is both a product and an advice service. This is 'generally' the case because ASIC uses these terms interchangeably in its regulatory guide RG 179 Managed discretionary accounts (RG 179) and recognises that the terminology used throughout the industry varies.

The Australian Securities and Investments Commission (ASIC) has acted on this in the form of its Regulatory Guide 97 Disclosing fees and costs in PDSs and periodic statements (RG 97), which comes into effect from 30 September 2022, and for which RG 97 states:

For PDSs given before 30 September 2022 you must comply with [CO 14/1252]. The transitional version of RG 97 (released March 2017) applies to these PDSs.

For PDSs given on or after 30 September 2022, you must comply with ASIC Corporations (Disclosure of Fees and Costs) Instrument 2019/1070.

However, in terms of election arrangements, RG 97 makes the following qualification:

You may elect to apply the updated requirements if the PDS is dated on or after 30 September 2020. If you do so, you must comply with ASIC Corporations (Disclosure of Fees and Costs) Instrument 2019/1070 for that PDS and subsequent PDSs.

In the lead-up, Zenith has observed significant variability in fee disclosures.

Moreover, the presence, or otherwise, of underlying fund performance fees may have distorted the disclosed cost of a managed account and potentially dissuaded investors from accessing appropriate fund options.

Further, performance fees and returns are co-dependent, and investors seeking the 'cheapest portfolio possible' may have capped the risk-adjusted return potential of portfolios.

A growing number of advisers use managed accounts for the many benefits this structure provides for their clients and broader business. In the process of establishing their suite of managed accounts, advisers must also understand the nuances that exist in how fees are structured and disclosed to ensure their clients fully understand them. Unfortunately, the inconsistent application of ASIC's fee guidelines has added a layer of confusion that has made comparing managed account portfolio options more challenging than it should be in recent years.

Exchange-traded funds (ETFs) have been one of the remarkable success stories of the Australian sharemarket. From when they were fist listed in late 2015, they now have a market capitalisation of $120 billion on the Australian Securities Exchange (ASX), providing investors with an ever-growing range of investment strategies.

There are many reasons why ETF managers have been able to roll out a steady stream of new products and why investors continue to support these funds. Their variety, low cost, and ability to provide investors with exposures to multiple stocks in a single trade have attracted a growing legion of fans.

AUSIEX's Australia's trading transformation report of June 2021 showed that ETFs were increasingly being favoured by advisers for ease of implementation and price.

ETF take-up by advisers trading through platforms more than doubled during COVID-19 as accounts went from an average of one in five trading an ETF pre-COVID, to over half during COVID-19, and two in three by the start of 2021.

But the convenience and variety of funds does not mean advisers or investors should see them as 'set and forget' means to play the market. With the market shakeout during the June quarter, it has been a valuable time for investors to review their holdings.

First, it is important to know the differences and benefits between an IMA, an SMA, managed funds and other investment structures.

The 2019 research looked at firms using managed accounts compared with peers who had not yet chosen to introduce managed accounts into their practices. Further, it sought to prove widely held beliefs about managed accounts and their impact on business efficiency, client engagement and practice profitability.

Among a host of insights, the 2019 research categorically proved that the use of managed accounts directly drove significant improvements in three critical business areas, namely:

• deeper client engagement
• increased business productivity
• the multiplying effect (i.e. escalating benefits that came from using managed accounts for a longer period).

In revisiting its research, Praemium analysed unique and exclusive data collected from 224 advice practices who completed the Business Health HealthCheck survey between January 2020 and December 2021. Of these, 76 firms were using managed accounts as part of their investment recommendations.

The rapid growth and increased adoption of managed accounts showed that many advisers are seeing the benefits that were proven in Praemium's research a short two and a half years ago. Moreover, the benefits of managed accounts translated into a business mindset that helped drive real success.

In the current environment, index-aware global bond investors face significant risks posed by a combination of rising market yields in 2022 and long-duration portfolio holdings. They have become increasingly concerned over their exposure to rising rates, how quickly rates will rise, and just how large the potential drawdown on a portfolio of global government bonds might be. This paper looks to address some of these key concerns, in particular what can be done to mitigate the risks from rising rates.

We believe that one possible solution is for investors to take steps to mitigate potential duration-led losses ahead of any major upward move in yields. To succeed, decisive action will be required by asset owners to ensure that their fixed income managers have the flexibility they need to manage duration risk more aggressively in an elevated inflation, rising-yield environment.

One way to acquire some insights into the potential risks is to look at scenario tests based on past periods of rising bond yields. For a scenario approach to be successful, a relatively reliable model of monthly bond returns appears essential. Fortunately, such a model is feasible, based on a three-factor approach to estimating total returns, namely the initial yield, duration, and roll-down return. Such a model is described later in the paper.

By way of historical background, looking at the top 10 government bond markets included in the Bloomberg Global Treasury Index from February 1987, the US and Japan each accounted for around 25% of the global market share, while the top 10 markets combined have a share of over 83% and, so, will clearly be the major drivers of global government yields.

In every one of these markets, the trend in government bond yields over the past 30-plus years has been lower, while the trend in duration has been higher. Nominal yields are close to historic lows, and, in some cases, yields are even negative.

This observation is very important for fixed income investors, since over medium-to longer-term horizons, the total return from government bonds tends to be close to their initial yields. This suggests that in the current environment, global bond investors should be conservative in terms of their future return expectations. The nature and importance of the initial yield-to-total return relationship is worth elaborating further.

A strong trend has emerged as recent adviser surveys [conducted by fintech provider Broadridge Financial Solutions in 2021 and summarised in its The Evolving Advice Business Model publication] report that 62% of financial advisers use separately managed accounts (SMAs), and that number is even higher among advisers under 40 (70%). In addition, 56% of advisers who use SMAs also plan to increase their usage over the next two years.

Much of this trend is built on advisers seeking differentiation and becoming more focused on providing the best client-centric investment experience and more perceived client value. This is leading advisers to re-evaluate how best to be equipped with the right tools and investment products to service their clients and investment portfolios in this evolving financial services business environment geared to 'personalisation'.

Unfortunately, many financial advisers and wealth management firms are at the mercy of their organisations's numerous and sometimes disparate technology systems, many of which are outdated, inefficient, and error prone. Add that to the ever-changing regulatory environment pushing stringent standards often creating a maze of policies, audit, and oversight requirements that must be followed when providing investment advice.

There are four key pillars to successful investment governance and therefore good investment decision-making:

• Skills-having skillful investment professionals at the core of the investment process.
• Resources-the tools and advice considered in decision-making, including external resources.
• Time-more time focusing on strategic decisions through thoughtful consideration.
• Process-a clear process and decision criteria.

Having the right mix of these in place, positions self-determined advice and wealth firms well to build out a private label managed accounts portfolio and should deliver better outcomes for clients.

Therefore, as a firm moves to implement a managed accounts program, there exists a key set of governance considerations:

• What mix of internal and external skills and resources will be employed to set both the appropriate mandate and undertake the ongoing management of the program? Who has the investment skill and what is your portfolio management technology?
• How much time will be dedicated in the form of investment committee meetings and other research and reviews, including due diligence on managers and securities? Do you have sufficient resourcing to conduct fiduciary level due diligence on fund managers and securities?
• What processes, framework and delegations will be in place to inform decision making? How will you stick to the strategy when markets turn against your approach? How do you make portfolio trade-offs between risk, return, fees, diversity, complexity and sustainability?

Up until recently, Australian investors were largely immune to this lack-of-yield phenomenon, with relatively healthy domestic interest rates and solid performance from traditional fixed income strategies. However, since the last interest rate hike in November 2011, Australian interest rates have been falling, impacting the return on cash holdings as well as traditional fixed income expected returns.

In 2020, the economic impact of COVID-19 finally forced the Reserve Bank of Australia (RBA) to join other central banks to engage in a (near) zero interest rate policy as well as undertaking quantitative easing, thereby flattening the yield curve and lowering long-term yields for investors and savers.

While most credit strategies experienced mark-to-market losses in Q1 2020, these have largely been recovered, with credit spreads now at multi-year lows, as seen in Figure 1. Specifically, as of 31 October 2021, the RBA cash rate stood at 0.10%, Australian 10-year Government Bonds were yielding 1.9% and the primary global bond index was yielding just 1.2% (Vanguard Bloomberg Barclays Global Aggregate ETF, 31 October 2021).

With global actuarial management consultancy Milliman verifying the information used in the scenarios, the paper illustrates the costs of delayed implementation where an adviser is managing client portfolios manually on a client-by-client basis outside of a managed portfolio structure rather than using managed portfolio functionality available on platform.

Applying actual data from client portfolios on the HUB24 platform, this paper explores the benefits derived when portfolio changes are implemented when needed, rather than merely at set fixed points in the year.

Using managed portfolios, advisers can outsource investment decisions to managers, giving them the confidence that their client portfolios are kept up to date, reducing the administration burden of traditional portfolio management processes. Further, portfolio managers can control rebalancing frequency as and when needed with the knowledge that implementation is automatic, allowing investors to capture the maximum potential benefits of investment decisions.

As the scenarios are for illustrative purposes only, it remains important for advisers to consider the particular circumstances of their clients, as outcomes may differ depending on market circumstances at the time.

Amidst this backdrop, there has been ongoing rhetoric about the prospects of a re-emergence in inflation, and ultimately the impact this may have on the forward prospects for asset classes and at a time where many are trading at rich valuations relative to historical averages. This matter is further complicated by factors such as unintended outcomes from central authorities unwinding quantitative easing (QE) and governments removing fiscal stimulus from the economy.

In past years, Zenith has written extensively about the theoretical merit of real return (RR) funds, noting that their flexible investment mandates provide them with greater optionality compared to their strategic asset allocation (SAA) counterparts to adjust asset class exposures in response to changing market conditions. However, little consideration has previously been given to their inflation protection qualities, noting that many have investment objectives linked to the Consumer Price Index (CPI).

Accordingly, the following discussion will explore the forward prospects of RR funds in an environment where there is a resurgence of inflationary pressures. In undertaking this analysis, consideration will be given to the concept of inflation, the challenges in setting a portfolio where pricing pressures are building, the inflation protective qualities of RR funds and ultimately the challenges they may face in delivering upon targeted objectives.

At the height of market volatility in 2020, Macquarie saw prolonged trade volumes over a number of weeks. For many financial advisers, it was a true test of the managed accounts model. Those using managed accounts could quickly adjust strategies-across hundreds of clients simultaneously-without having to chase authorisation or choose who would benefit first. Advisers could also easily invest in new opportunities as they emerged, and had more time to be available for clients during a period of great uncertainty.

From a client's point of view, this ability to respond was more or less assumed. Salesforce's State of the Connected Customer report of October 2020 found that client expectations of technology use have accelerated, especially after experiencing new standards of digital service throughout the pandemic. This report and Macquarie's Propensity Project research have found that for some time, client satisfaction has been largely driven by proactive management of their portfolio to achieve the best risk-return outcomes.

This paper will explain:

• the difference between managed accounts and managed funds
• what are MDAs, SMAs and IMAs and how do they work
• the pros and cons of managed accounts.

What is a managed discretionary account (MDA)?

An MDA is a personal investment account where the investor signs a contractual agreement to give the MDA provider the authority to buy and sell investments, for instance shares or units in a managed fund on their behalf. MDAs work on a portfolio investment model. This means the MDA provider holds a 'basket' of investments and investors buy and sell units in the basket.

The MDA provider is often a financial adviser who manages the MDA as an investment portfolio for their client(s). If a financial adviser does this, they must have authorisation from the Australian Securities and Investments Commission (ASIC) to both provide MDA advice and act as an investment manager. However, some financial advisers use the services of professional MDA investment managers and only provide advice services instead.

It is important to understand that an MDA is an advice service and not a financial product. The MDA provider must develop an investment program in consultation with the investor and include it in a Statement of Advice (SOA) that is reviewed at least every 13 months. This review should consider any changes to the individual's financial needs, goals and risk tolerance level during that time, as well as any changes to financial market conditions.

For example, an individual may have income needs, growth goals, or a combination of both. They may be prepared to tolerate higher risk for potentially higher returns, and this may, or may not, be suitable for their age and current financial situation. This should be a major consideration when their investment program is developed.

The assigned authority of the MDA provider to make investment decisions on an individual's behalf is where the word 'discretionary' comes from in relation to managed discretionary accounts. The MDA provider has the discretion to buy and sell any investments based on the mutually agreed investment program. Any investment decisions the MDA provider makes on an individual's behalf must be consistent with this strategy. The MDA provider charges fees for the services they provide, and they are usually tax deductible. The MDA provider is also responsible for all MDA regulatory reporting and compliance.

Many MDAs are hosted via online investment platforms where assets can be easily and quickly bought and sold. The value of these online accounts is also very transparent. Any assets bought and sold in an MDA are owned by the investor as the account owner. This means that investors will benefit from any franking credits that may be received. Franking credits provide a tax credit for any Australian company tax paid on dividends received. Tax credits can be used to reduce the investor's tax liability to the Australian Taxation Office. As such, an investor with their MDA adviser can plan to maximise the tax effectiveness of their investments based on their personal situation.

Question 1: Are MDAs overhyped and overused?

Peter

No, not at all. Any hype is a reaction from a group gaining huge efficiencies for their practice which leads to lower costs for clients and advisers being able to make active portfolio changes when the time is right. This can lead to better investment performance and lower costs for clients. There are many practices that are yet to see the light.

Sean

A little bit. There is no doubt that using an MDA, or what I prefer to describe as a discretionary facility, can provide huge efficiencies to practices and simplify portfolio management; but not every client situation requires an MDA, and sometimes there are better options.

I think that discretionary facilities provide significant benefits to clients, licensees and advisers when they are used correctly, but too much of their promotion focuses on the significant benefits to the licensee/practice rather than on the real benefits they provide to clients.

They can also create, or maximise, a range of conflicts that often work to a client's detriment. I appreciate that some of our clients tackle this tension in a pragmatic and effective fashion by using the time they save on administration to build better engagement with their clients and provide more tailored, more considered personal advice.

I would not be able to call myself a lawyer if I did not offer you an entirely contradictory position at the same time; because of their experience with old-school platforms, advisers often fail to appreciate the real capabilities of MDA services and properly utilise their full capability. Thankfully, experts like Peter Turbach, [Mason Stevens' managing director] Tim Yule and [Institute of Managed Accounts Professionals' chair] Toby Potter are helping licensees and advisers uncover the hidden value of these facilities.

One of the challenges for financial advisers in understanding managed accounts and selecting managed accounts services, is the diversity of offerings available. It can be a confusing landscape. Different managed accounts solutions offer different levels of completeness as a business solution. These differences impact the level of business improvements available to advisers and how the solution can benefit their investor clients.

This paper aims to help advisers fully grasp the scope of managed accounts services and their benefits to advisers, their businesses and their clients.

Managed accounts terminology

A managed account is a portfolio of individual investment assets, managed on behalf of an investor by a specialist professional investment manager. The investment manager does all the work surrounding research, implementation and reporting. Their role is to make timely investment decisions within the portfolio, manage asset allocation, select the underlying investments, portfolio weights and portfolio rebalancing.

Managed accounts can incorporate a range of portfolio management services. These include managed discretionary accounts (MDA), separately managed accounts (SMA) and individually managed accounts (IMA).

Under each service, the investor has beneficial ownership of the underlying investments, rather than share in a pool of assets through issued units in a unit trust. Because of this, managed accounts can be flexible and provide bespoke outcomes for managing exposures and tax outcomes to suit each client's specific needs. They provide control and transparency in helping advisers to deliver tailored client outcomes.

The primary benefit of an MDA is that following an initial agreement with the client, the MDA provider is responsible for the investment selection and the ongoing portfolio implementation without requiring ongoing client statements of advice (SOAs) and/or records of advice (ROAs) and Letter of Authority approvals.

MDAs, therefore, provide a far simpler advice and administrative solution for the adviser and investor and dramatically increase implementation speed. MDAs enable the benefits of dynamic asset allocation to be fully realised. They give investors access to a range of professionally managed individual asset class or multi-asset investment models. These can be tailored to an individual's risk tolerances or wealth objectives.

For financial advisers, managed accounts provide a means of delivering mass-customisable portfolio management services across multiple clients with greater efficiency. This provides a scalable investment solution for advice businesses, allowing advisers to concentrate on strategic advice, and freeing up time to grow and develop the business. The implementation of managed accounts can have a transformative effect on an advice business.

It is an opportunity to refine the practice's value proposition and align business processes behind it, as well as spearhead a better approach to client engagement and communication. Taking these steps will set up the practice to deliver the best possible outcome for clients and the business and, importantly, get the most from managed accounts.

Setting the scene

The events of 2020 demonstrate why it is important to respond quickly on behalf of clients when critical events occur in financial markets. As advisers are only too aware, the initial correction happened across just six weeks. By contrast, the last major market correction, the 2007/2008 global financial crisis, took 18 months to play out. The COVID-19 pandemic is very different and in such a fast-paced world, advisers need to be as efficient as possible. Which is why managed accounts can play such a vital role.

Managed accounts allow advisers to play to their strengths and concentrate on clients and their goals. They streamline the statement of advice process and result in less ongoing to and fro with clients. At an even more granular level, they elevate the requirement to place multiple trades on several administration platforms for scores of individual clients to professional investment managers, whose sole focus is monitoring portfolios and investment markets.

This leaves advisers with much more time, which can be invested in deepening relationships and providing value.

Many advisers acknowledge the benefits of managed accounts. For Lane Financial, managed accounts allow the practice to make more efficient use of its resources. "We only have one adviser, no paraplanners and a client services manager so managed accounts help us be more productive," senior financial adviser Morgan Collins said.

He explained that Lane Financial has been using managed accounts for about two years:

We have around 150 clients and we're growing quickly. We have a loyal, local client base and advise a lot of small business owners who are often starting out with only a small amount of capital. Managed accounts allow us to use external expertise to manage a portfolio and focus on strategic and structural decision making, while keeping client costs down.

ID Accounting and Wealth Solutions director Paul Bourke also explains why managed accounts make sense for his business:

We originally built the practice on in-house portfolio management. But we found ourselves spending too much time on portfolio management and not enough time on strategic advice, which is where the real value lies.

*This article is sponsored by MLC*

Rather than predicting when (or if) inflation will increase to disruptive levels, we aim to answer a simpler question: What passive and dynamic investments have historically tended to do well (or poorly) in environments of high and rising inflation?

Why does inflation matter for asset prices?

Treasury bond prices are obviously impacted by unexpected inflation. Their current prices reflect an expected real interest rate, an expected rate of inflation and risk premium. If there is an unexpected surge in inflation, the expected inflation embedded in the yield increases and the bond price usually falls.

If the new level of expected inflation is long lasting, bonds with higher durations will be more sensitive than those with shorter duration bonds. A change in the uncertainty about inflation rates may also impact the risk premium.

Equities are more complicated.

First, higher and more volatile inflation creates more economic uncertainty, thus harming the ability of companies to plan, invest, grow, and engage in longer-term contracts. Moreover, while firms with market power can increase their output prices to nullify the impact of an inflation surprise, many companies can pass on the increased cost of raw materials only partially. Margins therefore shrink.

Second, unexpected inflation may be associated with future economic weakness. While an overheating may cause companies' revenues to increase in the short term, if the inflation is followed by economic weakness, it will decrease expected future cash flows.

Third, there is a tax implication for companies with high capital expenditures because depreciation is not indexed to inflation.

Fourth, unexpected inflation could serve to increase risk premiums (increase discount rates) reducing equity prices.

Finally, similar to bond markets, high-duration stocks (particularly growth stocks that promise dividends far in the future) are especially sensitive to increased discount rates.

The inflation mechanism for commodities, like bonds, is relatively straightforward. Indeed, commodities are often a source of inflation.

Alternatives refer to a wide range of investment assets that do not fit into the standard asset classes of equity, property, fixed interest, and cash.  To help clarify this rather broad definition, the alternatives universe is very wide with some of the more common alternative categories being hedge funds, private equity and debt and unlisted infrastructure, but can also include highly bespoke investments such as artwork and vintage cars!

Alternatives heterogeneous nature explains why it is often the most difficult asset class for investors to grasp, and consequentially, alternatives are often excluded from portfolios.  One of the great misconceptions regarding alternatives is that they are high-risk, highly illiquid investments, reserved exclusively for large institutional or high net worth investors.

On the contrary, there are many liquid alternative investments now available and accessible to private investors via the various administration platforms. This is important as selected alternatives strategies can dampen volatility (risk), add to portfolio diversification and maintain attractive liquidity characteristics.  Today, individual investors have greater access to alternatives than ever before.

Why are alternatives so important?

Many alternative investment strategies have a reasonably low correlation with traditional asset classes, meaning they tend to perform differently over time in varying market conditions.  This intuitively explains why alternatives can improve diversification in a diversified portfolio.  Diversification is perhaps the most fundamental, well-accepted concept within investing. Investors can reduce their risk by diversifying across different asset classes, sectors, and regions. This simple yet powerful principle is a ubiquitous objective for most investors.

By enhancing portfolio diversification, alternatives can help lower volatility, reduce the severity of drawdowns (the peak to bottom capital decline during a specific time period) and permanent capital loss, and introduce an 'alternative' source of return to help investors meet their return objectives.  Such benefits are especially important in the current low growth, low interest rate environment, in which persistently falling interest rates have inflated traditional asset class valuations and lowered future return expectations.

To further complicate matters, low bond yields challenge the defensive capabilities fixed income assets have historically played in a share market downturn, as bonds are now broadly susceptible to capital depreciation should interest rates rise from their historic lows. While traditional equity and fixed income investments have long been considered the key components of a diversified portfolio, investors should consider using alternatives as an additional avenue to meet their return objectives and lower their risk.

As markets peaked and troughed in a matter of weeks, those investors guided by the steady hand of a financial adviser were most likely reassured to take a long-term view.

Investment decisions were made with the considered approach of experience and not a knee-jerk reaction to market volatility.

Yet while the need for financial advice has never been greater, the cost of delivering that advice continues to be a challenge. For many businesses, the focus is on reducing cost, and many progressive advice firms have already moved to a flat fee-for-service model (beneficial during the COVID-19-induced market volatility), in conjunction with outsourcing as much of their back office as possible.

However, managing costs is not the only key to achieving business success. Having worked with many advice practices over the last three decades, my experience shows that the most successful firms have all had a clear and well-developed approach to a number of aspects that make up the advice value chain.

Getting these aspects right can help practices create sustainable business models that are focused on delivering high-quality, cost-effective and scalable advice.

This paper outlines five key factors to enhance the advice value chain and achieve the aforementioned goals.

Clearly defined investment proposition

Establishing a simple to understand, client-friendly investment proposition that can be easily articulated to clients, and implemented in an efficient and scalable way, is a crucial link in the advice value chain. The most successful advice businesses have a common attribute-they are able to take complex concepts and simplify them as much as possible to provide ongoing confidence and peace of mind for their clients.

Trying to imagine the future is a difficult task in normal times. As the times we are living through are anything but normal, marked as they are by a very high degree of uncertainty, identifying the likely direction of events is even more challenging. Nonetheless, we have identified five key themes we believe will drive the performance of economies and markets over the coming 12 months and beyond:

1. Post-pandemic road to recovery
2. Politics and the pandemic
3. Policy and low yields
4. Parting styles amid disruption
5. Pricey safety.

As these dynamics play out, we have identified a range of investment ideas we believe may be effective in helping to navigate the period ahead.

The COVID-19 pandemic is adding to the uncertainty. Periods such as these emphasise both the value of good advice and the role of technology in providing solutions to protect and create value for clients. Managed portfolios have proven to be a popular investment vehicle for advisers, providing their clients with access to cost-effective professional investment manager expertise while the client retains the benefits of beneficial ownership in IDPS and the Trustee retains these benefits in Super. Evidence of these benefits is the impressive

growth in Funds Under Management (FUM). As of December 2019, FUM in managed portfolios in Australia stood at over $72 billion Australian dollars, representing a Compound Annual Growth Rate (CAGR) 11%3. On HUB24, managed portfolio Funds Under Administration (FUA) has been growing at a much faster compound annual growth rate of 57% over the past four years.

Adviser adoption of managed portfolios has been supported by enhanced functionality driven by innovation available on platforms, which can provide additional benefits to clients.

Over the past couple of years, competition in the broader platform and superannuation market has focussed on fees, with the emergence of flat fees combined with cut down investment menus. While product choice is critical to service the advice needs of different client segments, focussing on price alone could come at the cost of significantly increased client value-driven by product capability available on platforms.

The managed accounts market has matured in Australia-advisers can now consider independent ratings when evaluating options, for example. But there is still further potential for growth, and that is an opportunity that fund managers and advisers are paying close attention to.

In a recent virtual roundtable forum for Macquarie Wrap advisers and fund managers, we discussed the key issues surrounding managed accounts today, and the emerging trends we are seeing in the market. With increasing scrutiny from regulators, it has never been more important to consider best interests duty requirements and fee transparency. An active management approach in recent times is also proving to be key for fund managers seeking to extend their offering to incorporate managed accounts, with a trend towards combining both active and passive strategies in a complementary manner.

Bringing a legal perspective to the event, MinterEllison Financial Services Partner Richard Batten described managed accounts as "useful structures that can enable better outcomes for investors and advisers, while also helping them meet regulatory requirements". These 'better outcomes' can include tax advantages, the ability to personalise investments, and the agility to react quickly to market changes. "They also enable advisers to tap into specialist investment expertise - to go above and beyond the knowledge any single adviser would be expected to have," noted Batten

"We see managed accounts as providing a really valuable addition to the types of solutions available to advisers, and we also see an increasing demand for them-both on the adviser's and on the client's side," he added

Macroeconomic currents

On 13 March 2020, the All Ordinaries saw an 8.1% drop in the market. At the end of the day, the market was 4.1% up. This is the fastest peak-to-trough sell-off in market history. The move from the 20 February 2020 peak at 7,230 points to 4564 points at 22 March was dramatic. At the time of writing, some five months later, the All Ordinaries was back up at 6130.

These shifting seas are a product of wave after wave of major events. COVID-19 statistics loom large on the daily news bulletins. Record government stimulus is being pumped into the economy. Interest rates are at record lows. Billions in superannuation is being accessed early. All of these events have come together to create the perfect economic and health maelstrom. The need for financial advice relationships and timely investment management is more important than ever.

What the COVID-19 crisis has shown is that portfolios can quickly drift from the desired asset allocation weightings. If a traditional model portfolio is not rebalancing regularly, the client is potentially drifting off course.

Changing tack in stormy seas

Leon de Wet, EAM shareholder and portfolio manager broke the current situation down very simply in a recent portfolio update: "The speed at which markets fell and then subsequently rebounded not only created investment opportunities, but also meant investors needed to deal with portfolio asset allocations that did not match intended strategic allocations, with the differences potentially large and constantly changing. An advantage of managed accounts was that we were able to respond quickly, and importantly, simultaneously across all client accounts to ensure nobody was disadvantaged."

He added that being able to respond quickly was shown by various actions EAM undertook across its diversified portfolios, which included:

• reducing cash in terms of re-positioning for an expected recovery through increasing allocations to infrastructure, Australian equity and corporate credit
• rebalancing regularly so as to ensure the desired split not only between growth and defensive assets, but also the underlying holdings
• increasing exposure to international equities
• adjusting individual position weightings and adding new positions (eg. Beach Energy and Sydney Airport Holdings) in Australian equities.