FNCE20003 Lecture 5: Passive Management Styles

Passive Management Styles

• Approximately 90% of portfolio return results from asset allocation decisions.
• Minimal value is added through the selection of specific assets within asset classes.

Strategic Asset Allocation (SAA)

• SAA involves setting target allocations among different asset classes.
• Focuses on efficient allocation and the "buy and hold" strategy.
• Assumes aggregate asset classes are priced efficiently, with no abnormal profits from switching.
• Managers periodically rebalance portfolios to align with target allocations.

Tactical Asset Allocation (TAA)

• TAA is approached when managers believe certain asset classes are mispriced.
• Mispricing typically references short-term discrepancies between asset classes.
• Active strategy aiming to outperform passive benchmarks through market timing.
• Empirical evidence suggests difficulty among managers in successfully timing the market.

Dynamic Asset Allocation (DAA)

• DAA refers to periodic rebalancing of portfolio weights under SAA and TAA strategies.
• Some equate DAA with market timing within TAA, while others see it as a strategy to replicate return distributions.
• Involves tactics like portfolio insurance and stop-loss strategies.

Investment Asset: Cash and Bonds

• A bond is a contract between issuer and investor, with obligations for specified cash payments.
• Payments include principal plus interest; classified into coupon-paying bonds and zero-coupon bonds.

Coupon-Paying Bonds

• Regular interest (coupon) payments and principal repayment at maturity.
• Coupon rate may differ from market rates but is generally close at issue date.
• Cash flows are structured as: initial investment followed by regular coupons and final principal repayment.

Zero-Coupon Bonds (ZCB)

• ZCBs provide no interest payments, only a single principal payment at maturity.
• Issued at discount to par value; effective interest is the difference between face value and purchase price.
• Includes commercial bills and treasury notes known as pure discount securities.

Bond Valuation

• Valuation based on present value principles considering cash flows, time to maturity, and yield.
• Yield changes are discussed in basis points, where 100 basis points equal 1%.

Other Bond Types

• Types include convertible, callable, annuity, asset-backed, indexed, and junk/speculative bonds.
• The classification of bonds into “investment grade” reflects their creditworthiness.

Australian Bond Market

• Comprises government and corporate bonds; government bonds are low risk and corporations higher risk.
• Non-government bonds outstanding around $1.4 trillion, roughly 50% of ASX company value.
• Total ASX market capitalization reported at $2.6 trillion as of May 2024.

Cash Management Trusts and Bond ETFs

• Smaller investors face challenges with large investments in bonds.
• Broader investment options include international equities for further diversification.

Stock Selection Methods

• Common stock selection methods include fundamental analysis, technical analysis, and random selection.
• Random selection aligns with portfolio theory and diversification principles.
• A wide array of services exists in the industry focusing on the first two analysis methods.

Share Price Forecasting Game

• A forecast game for the closing share price of Bapcor (BAP) and Karoon Energy (KAR) will take place.
• Participation is voluntary; potential for bonus marks up to 2%.
• Forecast submissions are due by a specified deadline, with winners announced later.

Shareholder’s Marginal Tax Rate

• Individual shareholders are taxed on company net income before tax, subjecting them to their marginal tax rate.

Income Tax Calculation Example

• Gross salary of 125,000withafrankeddividendof125,000 with a franked dividend of 125,000withafrankeddividendof1,400 and unfranked dividend of $750.
• Work-related deductions amount to $1,800; the Low Income Tax Offset (LITO) does not apply due to high income.
• Taxable income (TI) calculated as gross salary minus superannuation contributions (11.5%).
• Final taxable income is 112,075,resultinginataxliabilityof112,075, resulting in a tax liability of 112,075,resultinginataxliabilityof26,052 after applying the relevant tax rates.

Tax Rules and Offsets

• Tax-free threshold is 18,200,withalowerthresholdof18,200, with a lower threshold of 18,200,withalowerthresholdof416 for unearned income of minors.
• LITO aids taxpayers earning up to 66,667,reducingtaxuptoamaximumof66,667, reducing tax up to a maximum of 66,667,reducingtaxuptoamaximumof700 for income up to $37,500.
• Individuals can earn up to $21,884 before any income tax is imposed.

Home Ownership Considerations

• Major financial decision involving the choice between renting and buying a home.
• Factors influencing this decision include savings discipline, capital appreciation, and tax implications of owner-occupied housing.

Share Price Movements

• Share prices react to new information, economic cycles, and herd mentality.
• Efficient Market Hypothesis (EMH) suggests that stock prices reflect available information, leading to consensus-driven movements.

Methods of Stock Selection

• Different stock selection methods include fundamental analysis, technical analysis, and random selection.
• Random selection aligns with diversification principles and portfolio theory.

Fundamental Analysis

• Professional advisers use company data and market resources to guide investments.
• Stock exchanges and brokers provide essential research and financial reports.

Transaction Costs and Documentation

• Transaction prices vary by service; online transactions are typically the least expensive.
• Documentation for shareholding includes contract notes, holding statements, and dividend distribution statements.

Buying Shares

• To invest in shares, establish an account with a broker, considering investment strategy based on available savings.
• Strategy could involve regular savings or one-off transactions utilizing different stock selection techniques.

Taxation of Capital Gains

• Capital gains taxed at an individual's marginal tax rate; long-term gains (held >1 year) are typically subject to a 50% discount.
• Example: Selling shares results in taxable income adjusted for costs.

Taxation of Dividends

• Dividend imputation system aligns dividend tax rate with the shareholder's marginal tax rate.
• Corporate tax paid on earnings adds to net dividends, which are grossed up for tax calculations.

Land (Stamp) Duty

• State governments impose stamp duty based on property sale price; higher prices incur higher duties.
• Example: Victorian stamp duty on an 850,000propertycantotal850,000 property can total 850,000propertycantotal46,070.
• First home-buyers enjoy special reductions, and purchasing land to build can lower duty costs.

Additional Costs in Property Purchase

• Extra government fees include mortgage registration and transfer fees; an example costs approach $2,088 for transfer.
• Borrowing costs may include establishment fees (400−400-400−600) and valuation fees (~250),alongsidesolicitors’fees( 250), alongside solicitors’ fees (~250),alongsidesolicitors’fees( 500).

Alternative Home Loans

• Various mortgage types include fixed-rate, interest-only, low-start, and hybrid "cocktail loans."
• Mortgage offset accounts can provide tax savings.

Rent vs. Buy Decision

• Young individuals often face the challenge of deciding between purchasing a home or renting.
• Buying leads to eventual ownership after mortgage payments, whereas renting offers flexibility without long-term property obligations.

Longevity and Aging Population

• Life expectancy for 65-year-old males is approximately 20.2 years.
• Over 35% of women and 21% of men are predicted to live to 90 or older.
• The working-age population (20-65 years) is at its lowest, financing pensions for those over 65 becoming more challenging.
• By 2031, the ratio of working-age individuals to those over 65 will decline to less than 3:1.

Retirement Risks

• Longevity risk: The possibility of outliving retirement savings.
• Inflation risk: The potential for inflation to diminish purchasing power over time.
• An increasing tax burden on workers is expected to fund pensions as each generation supports the retirees.

Superannuation and Retirement Schemes

• Australia primarily uses Defined Contribution (DC) plans which depend on individual contributions.
• Defined Benefit (DB) schemes are phasing out, making retirement lump sums less predictable for employees.
• Workers are often unable to fully fund adequate retirement income due to insufficient participation in retirement schemes.

Superannuation Guarantee System (SGS)

• Employers must contribute 11.5% from employees’ salaries into an approved superannuation fund.
• Employees can choose investment options but will default to a MySuper account if no choice is made.
• Access to funds is restricted until the employee reaches 'preservation age'.

Complying Superannuation Funds (CSFs)

• CSFs must be resident funds controlled in Australia and comply with the Superannuation Industry (Supervision) Act 1993.
• Significant national savings have been observed since the introduction of the SGS.
• The SGS positively impacts the Australian Stock Exchange, debt markets, and infrastructure investment.

Contributions to Superannuation

• Contributions can be made by employers, personally, on behalf of a spouse, and under certain employment awards.
• Concessional contributions include compulsory employer contributions and voluntary salary sacrifice.
• Non-concessional contributions consist of after-tax income sources.

Taxation and Contribution Limits

• A super fund may accept mandated employer contributions up to $30,000 per year (increased from $25,000).
• Salary sacrifice contributions are pre-tax and subject to a 15% contributions tax.
• Specific criteria apply to contributions based on age and employment status.

Implications on Retirement Funding

• The future value of accumulated funds heavily depends on factors like the earning rate, salary growth, contribution rate, and duration in the scheme.
• Inflation could reduce the purchasing power of accumulated retirement savings significantly over time.
• Factors adversely affecting accumulation include employment gaps, poor investment choices, and legislative risks.

Divorce Impact on Superannuation

• About 40% of marriages in Australia end in divorce, which can lead to superannuation asset splitting.

Overall Financial Planning Considerations

• Proper planning must account for longevity, inflation, potential changes in contributions, and personal circumstances.
• Maximizing contributions and understanding the superannuation framework are essential for building a sustainable retirement fund.