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‘Lifestyling’ an investment portfolio

For such a lifestyling to work in practice, a diverse and liquid bond market is fundamental.

For such a lifestyling to work in practice, a diverse and liquid bond market is fundamental.

Before setting out to assist in building what all investors hope would be the perfect portfolio, it is important to understand the investor’s objectives and financial background to ensure that the recommended investments suit that person’s requirements.

The process of increasing the bond allocation as an investor ages is normally referred to as ‘lifestyling’
- Edward Rizzo

Another factor which is very important is the investor’s age. A higher allocation to shares, which should generate better returns over an extended period of time, is more suitable for younger people who are not dependent on their investment portfolio for income. Younger investors tend to have the ability to easily ride out the customary wide periods of volatility inherent in most shares.

On the other hand, as an investor approaches retirement age, an increased allocation to bonds is normally recommended as many retired people become more dependent on the income generation of their portfolio to supplement their other sources of income, mainly their pension. This requirement has become even more important as the cost of living has risen and interest rates have declined to historically low levels in the aftermath of the international financial crisis.

There is a general rule advocated by some academics that one’s bond allocation in an investment portfolio should equal one’s age. Therefore, a 30-year old starting off an investment portfolio should only retain a 30 per cent allocation to bonds with the balance of 70 per cent in equities and other asset classes, such as property and commodities. On the other hand, a 65-year old should have a bond allocation of at least 65 per cent with the balance of 35 per cent in company shares and other assets.

The process of increasing the bond allocation as an investor ages is normally referred to as ‘lifestyling’. International financial advisors actively promote this concept and carry out automatic increases in bond allocation regularly for their clients to achieve what they view to be the ideal bond exposure to insulate portfolios from dramatic swings normally seen in equities. Such automatic ‘lifestyling’ is not the norm locally as independent financial advisors structure a client’s portfolio based on each person’s unique requirements. Therefore, periodic reviews of a portfolio are necessary not only to make any changes in line with market developments but also to amend the asset allocation to suit a client’s objectives.

For such a lifestyling to work in practice, a diverse and liquid bond market is fundamental. Unfortunately, the development of the local bond market has stalled over recent years, thereby providing limited scope for local investors to continue to increase their allocation to the local corporate bond market without ending up with excessive exposure to some individual group of companies or Malta Government Stocks. In this respect, portfolios of local investors are already generally very overweight in Malta Government Stocks. The current lack of availability of new local bonds needs to be addressed. In the absence of a more diverse corporate bond offering, capital flight overseas will inevitably grow to the detriment of local companies that may need to diversify their sources of funding for their continued investment requirements and naturally the local economy as a whole.

Over recent years, lifestyling a portfolio has been regarded as the most sensible strategy as it sheltered many pensioners from the full effects of the occasional stock market falls we have evidenced throughout the years. However, as always, the timing of changes to the asset allocation in an investment portfolio plays a very important part, especially as one approaches retirement age and certain setbacks will prove difficult to recover from.

As an example, it would have been detrimental for any investor (even if one is fast approaching retirement age) to automatically reduce his equity holdings when the market was at a multi-year low in March 2009 and instead invest in bonds. At the time, the FTSE100 index in the UK was at 3,500 points.

This has since increased to 5,800 points despite the wide periods of volatility. The same trend was evident in all major international equity markets as well as in Malta and therefore an automatic shift away from equities in 2009 into bonds would have surely not been the ideal shift to make to a client’s portfolio.

Likewise, the same can be true today with respect to the bond market. As a result of the significant decline in interest rates to historically low levels in response to the international financial crisis and global economic slowdown, bond prices rallied and yields dropped to all-time lows.

Additionally, the strong demand for bonds from the ever-increasing number of risk averse investors also played a part in the bond price rally. Yields on 10-year Malta Government Stocks have dropped to below four per cent per annum (from 4.85 per cent in 2007) and sovereign bonds of ‘AAA’-rated eurozone countries such as Germany, France and the Netherlands have declined to well below two per cent.

Automatic lifestyling is a strategy recently introduced overseas and the greatest concern at the moment is that this has never been tested in a bear market environment for bonds. Many international market analysts have regularly aired their views in recent months that some bond prices have been driven to excessive levels by investors seeking safe havens and a bear market is inevitable unless perpetual deflation is on the horizon.

Such analysts fear that once economic conditions begin returning towards normality, there could be a severe drop in bond prices. Although the income generated from a bond portfolio will be maintained, a bear market for bonds could have a significant impact on the value of an investor’s portfolio mainly exposed to fixed interest rate securities. The risk would be greater in longer-term securities as well as bond funds with no fixed date of maturity as the price of the fund would reflect the current value of all the underlying investments.

A spokesperson for a UK stockbroking company was recently quoted as having said that if yields on long-dated bonds rise back to levels before the Bank of England embarked on quantitative easing, a typical bond portfolio could lose up to 30 per cent of its value.

So in view of the expected decline in the prices of ‘safe haven’ bonds in the years ahead, what alternatives should one consider for a well-balanced portfolio to be insulated from an eventual increase in interest rates? The most natural alternative would be to select companies producing attractive and sustainable dividends to shareholders which have a proven track record of rewarding shareholders adequately even in the midst of the global economic recession. There are plenty such companies across the international financial markets. In the UK, the most commonly cited candidates are Vodafone, tobacco companies such as BAT and pharmaceutical companies like Glaxosmithkline. In the US, PepsiCo, Microsoft, Pfizer, Procter & Gamble and Johnson & Johnson are some of the blue-chip companies well suited for income-oriented investors.

While some investors may feel comfortable selecting a few such blue-chips for a portfolio, others may prefer having an exposure to a much wider range of such dividend-paying companies. In this case, an Exchange Traded Fund focused on dividend companies could be an alternative worth exploring.

Locally, the banks have always been consistent dividend-paying companies through the years and even in the international financial crisis in 2008 and 2009 – unlike their larger foreign counterparts which had suspended dividends to shareholders. Similarly, Malta International Airport plc and MaltaPost plc have also produced attractive dividends to shareholders since their listing some years ago although the latter has suffered a setback in profitability this year and therefore the sustainability of the company’s dividend track record could be questioned.

Another high dividend company which is very often overlooked is Plaza Centres plc. Since its listing 12 years ago, dividends to shareholders have grown by a total of 55.8 per cent through the consistent improvement in the company’s profitability from one year to the next. This would be an ideal candidate for investors seeking a consistent dividend-paying company. Likewise, Malita Investments plc, which was the latest equity offering in Malta, was also structured with this objective in mind.

Other alternatives for an investor’s portfolio could be obtaining an exposure to certain commodities such as gold. However, in such a case, the underlying rationale would be to protect one’s portfolio against higher inflation rather than achieving a consistent return for income-oriented investors since such commodities do not provide annual returns.

The current financial market conditions pose significant challenges for investors seeking to alter their investment portfolio to cater for the changing requirements.

The need for professional assistance in this area is of paramount importance to ensure that an investor is not exposed to certain securities, possibly also complex financial instruments, which are not well understood and could have a damaging effect on one’s wealth and living standards.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, RFC, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2012 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

www.rizzofarrugia.com

Mr Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

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