World energy demand is expected to grow at an annual rate of 1% over the next 25 years. While renewable energy use will continue to grow, fossil fuels will remain the principal energy source. However, natural gas is the fastest growing fossil fuel and coal will continue to lose market share. This represents a significant opportunity for capital expenditure in energy infrastructure as the break-even price of shale oil continues to decline. 

The market keeps expanding 

Demand for energy is linked to population size and a country’s stage of economic development. Economic growth leads to an increase in living standards and demand for household necessities which drive the increase in energy use. The world population reached 7.6 billion in 2017. China and India remain the two largest countries in the world with a population of 1.4 billion and 1.3 billion, respectively. 
  The world population is expected to grow by approximately 1% per year, adding 1.6 billion people over the next 23 years and reaching 9.2 billion by 2040. Most of this growth is expected to occur in African countries, with strong additions also in India, Pakistan, Indonesia, and the United States.

Population in top 10 countries (million)

World GDP is expected to grow at an annual rate of approximately 3%, approaching US$150 trillion in 2040 and doubling over the next 25 years. Asia Pacific, including China and India, will account for almost half of the increase (US$37 trillion), followed by North America (US$15 trillion) and Europe (US$11 trillion).

Notwithstanding its robust population growth, Africa is expected to face a limited increase in GDP per capita and therefore to account for only around 5% of the increase in world GDP, but showing the highest compound annual growth rate (CAGR) of 4%.

The continued rise of natural gas 

The energy mix has been evolving over recent years. Fossil fuels (oil, natural gas and coal) have been the main source of energy, representing a stable 86% share of the overall energy mix. Oil consumption increased in absolute terms during the 2000-15 period, however its share of the energy mix declined by 5.8% from 38.6% in 2000 to 32.8% in 2015. This decline was offset by an increase in coal, mainly due to increased electricity generation in China. 

Energy mix breakdown

Nuclear power generation has been stable and its share of the energy mix has declined from 6.2% in 2000 to 4.4% in 2015. Renewables, mainly wind, experienced significant growth in the 2000-15 period, increasing their share from 0.5% to 2.7% of global energy use. The energy mix will continue to evolve in the future. Although fossil fuels remain the main source of energy in the global economy, their share of the global energy mix is expected to decline materially in the future. In absolute terms, oil, natural gas and coal will experience annual growth rates of 0.4%, 1.4% and 0.4%, respectively, during the 2015-40 period. 

Natural gas will be the fastest growing fossil fuel with an increasing share of the overall energy mix (from 24.0% in 2015 to 25.0% in 2040), driven by a vast North American shale gas resource base. Meanwhile oil and coal will continue to lose market share falling to 26.7% and 23.5% by 2040, respectively. The declining 2000-15 trend of oil use is expected to continue and coal will be impacted by continued coal-to-gas switching. Fossil fuels’ share of overall global energy use is expected to fall to 75.2% in 2040 from 85.6% in 2015. Renewables will continue to play an increasingly important role in the power generation mix in the future, with their share of the energy mix rising to 11% in 2040.

US Shale drive future production growth of oil and natural gas 

Oil and gas development activity has been evolving significantly since producers outside of OPEC started to use fracking technology to exploit the vast resource potential in North America. 

Technological developments in natural gas are expected to boost production from shale gas and associated gas from shale oil projects. Demand from industrial and electric power markets are expected to drive consumption of US natural gas at an annual growth rate of 0.6% over the next 25 years. However, production is expected to grow much faster (at an annual rate of 1.5%) resulting in an annual surplus of almost 6tcf (trillion cubic feet of natural gas) by 2040, as the US is expected to produce 38tcf and consume 32tcf annually. This amount will be exported through pipelines (e.g. 1.4tcf to Mexico in 2040) and liquefied natural gas (LNG) export terminals (4.4tcf in 2040). Most LNG is currently traded globally under oil price-linked contracts, but LNG produced in the US has the key advantage that domestic prices are less sensitive to global oil prices, which may change pricing dynamics in the future.

Investment opportunity in oil and natural gas storage and transportation

Monopolistic companies that own large and diversified networks offering attractive yields and growth opportunities from future projects represent compelling investment opportunities. Investors should aim to avoid businesses that are highly sensitive to volatility in volumes and/or commodity prices. They should look to identify companies that demonstrate: 

• Growth – from future projects 

• Cash flow stability – from fee-based contracts supported by strong regulationYield – derived from compelling shareholder returns 

Such an investment framework enables investors to capture long-term value in the energy infrastructure sector while avoiding short-term volatility in the commodity environment. North American energy infrastructure companies are today uniquely positioned to take advantage of the compelling long-term trends that are currently unfolding in the oil and natural gas supply industries.

To read the full paper click here.

To view the infographic click here.

Source: AMP Capital 12 October 2017

The post-GFC world of record low rates and quantitative easing (QE) created many ‘fashionable’ asset classes that outperformed, such as yield plays and defensive growth stocks including big tech companies like Amazon.

But almost ten years on from the GFC we are now shifting to a new macro environment as central banks like the US Federal Reserve make it clear they are shifting from QE to QT (quantitative tightening). 

There is a danger, however, that investors fail to react to the emergence of this new regime, and they get trapped in crowded ‘overly fashionable’ asset classes and expose their portfolio to significant damage when these assets are sold off. 

To avoid becoming ‘fashion victims’, in our view investors and advisers should be flexible and begin moving to assets that will outperform relatively as the global economy improves and central banks shrink their balance sheets. But they will also need to hedge against an increase in market volatility as the QE cushion is removed.

The good news is the shift to a new investment regime is throwing up some good opportunities, including high-conviction sector ideas like energy and financials.

1. A move to cyclicals 

The first major change investors may consider is altering equities allocations.  
Four years ago, we wanted to chase yield and were focused on REITs and other assets such as high-yield credit. But we have now moved a notch up in the economic cycle and shifted to a phase where global economic growth is becoming more sustainable and synchronised.

Therefore, we see value in increasing allocations to cyclical stocks such as energy, financials, materials, industrials and transportation stocks. We believe real assets such as commodities, metals and energy should also do particularly well, and our Dynamic Markets Fund, including the Active ETF DMKT, has a high – 10 per cent – allocation to commodities.

Within cyclicals and commodities, energy is emerging as a ‘high-conviction’ idea as the sector’s fundamentals move from ‘bad’ to ‘less bad’, creating a window of opportunity before most investors catch on.

Source: AMP Capital

The chart above shows a massive disconnect between the relative performance of energy stocks and the rest of the market. Global energy stocks have also lagged a rise in oil prices. No one believes oil prices will stay high because inventories are high. 

But, if you look closely, yes inventories are high, but they are coming down at a rapid pace. US shale oil production, a major cause of oil inventories rising, is clearly declining. New wells are interfering with old ones, and producers need to dig a lot more wells to keep productivity at the same levels. 

We believe oil prices are heading higher. Valuations are very cheap, and because there is a lot of pessimism the market is not seeing energy fundamentals get ‘less bad’. 

2. Financials – winners from shrinking balance sheets

The second major change investors need to adapt to is the impact of Central Banks’ moves to shrink balance sheets on the relative performance of asset classes.

Source: Bloomberg. Past performance is not a reliable indicator of future performance.

Central banks play a major role in the relative performance of asset classes. The chart above shows that as central banks expanded their balance sheet (the rising blue line) the tech sector (defensive growth) outperformed, but the financial sector suffered.

But as we move from QE to QT and that blue line starts coming down, that relative performance is likely to reverse and banks will perform relatively well.

We have an allocation to European and Japanese banks through ETFs because they were the most negatively affected financials during QE because interest rates there fell. Banks had massive amounts of excess reserves. They put those reserves with central banks and earned negative interest rates, damaging their profitability.

That underperformance means European and Japanese banks should have the most upside in QT.  

3. Hedging volatility and uncertainty

But investors also need to adapt to a likely increase in volatility.

Source: Bloomberg

As you can see in the charts above, QE supressed volatility. Every time news became bad, markets would go up because there was an increased possibility Central Banks would ease again. 

That lack of volatility means markets have become complacent. Markets are not pricing in a lot of uncertainty. US equities, for example, haven’t corrected for the past year and every correction gets bought into. (US equities are the most expensive in the world, so we are underweight.)

With markets not pricing in uncertainty, we have a high, 30 per cent allocation to cash. When the market does price uncertainty and corrects we can use that cash to re-enter.

Because QE dampened volatility, when it ends and central banks shift to QT we will therefore see upward pressure on volatility with a greater risk of corrections and setbacks. Investors should therefore consider hedging their portfolio.

One option is the $US. Given the negative sentiment against the $US – a massive turnaround since the start of the year – the $US has become a great hedge if portfolios correct. Our Dynamic Markets Fund is long $US against short positions in emerging markets currencies. (EM currencies are also a good hedge in case of war.)

Another possible hedge is gold. The probability of a nuclear war with North Korea might be low, but if it does happen the impact will be very high. One asset class that does well in every geopolitical tension or war in the past has been gold. If things escalate from here, gold prices are likely to multiply several fold. The Dynamic Markets Fund also has a 3 per cent allocation to gold as a tail hedge. 

The benefits of multi-asset investing

Loyalty, monogamy and trust are principles of life. But in investing those principles work against you. 

Like fashion, asset classes go in and out of vogue. In 2000 tech stocks were fashionable. In 2007, housing-related stocks in the US were. In 2010 resource stocks. And now yield plays and big tech stocks like Amazon are fashionable. 

But their performance has run its course, and as we move to a new macro environment and investment regime it’s time to look at shifting other assets.

In this complex regime shift, investment strategies like multi-asset investing — the strategy used to manage the Dynamic Markets Fund and DMKT – will thrive. Multi-asset investing gives us the flexibility and scope to change allocations depending on where we are in the cycle. And it also provides us with a disciplined process so we can find value, filter noise and remain objective.

Multi-asset investing allows us to stay away from the crowd and look at opportunities which are underappreciated. It allows us to be ‘fashionable’ but not end up as ‘fashion victims’. Investors and advisers need to follow that lead.

For information on listed investments including Active ETFs and DMKT, register for our upcoming webinar.

Source: AMP Capital 12 October 2017

Author: Nader Naeimi

Nader Naeimi has more than 19 years of experience in Australia’s financial markets, including 16 years at AMP Capital. As the Head of Dynamic Markets, he is responsible for leading the Dynamic Asset Allocation strategy for the Multi-Asset Group, as well as other macro strategies and asset allocations for several AMP Capital funds.

This article has been prepared by AMP Capital Investors Ltd (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”). BetaShares Capital Ltd (ACN 139 566 868, AFSL 341181 (“BetaShares”) is the responsible entity and the issuer of units in the AMP Capital Dynamic Markets Fund (Hedge Fund. AMP Capital is the investment manager of the Fund and has been appointed by the responsible entity to provide investment management and associated services in respect of the Fund. Investors should consider the Product Disclosure Statement (PDS) for the Fund before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. Neither BetaShares, AMP Capital, nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this information.

Past performance is not a reliable indicator of future performance.

While every care has been taken in the preparation of this information, BetaShares and AMP Capital make no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This content has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of this information, and seek professional advice, having regard to their objectives, financial situation and needs.

The AMP Capital Wholesale Australian Property Fund recently bought Stage 1 of the Connect Corporate Centre in Mascot, Sydney, a sleek, brand-new building close to the Sydney CBD valued at $43.6 million. 

What made the building so attractive? For a start, it has a list of blue-chip tenants that will deliver reliable income, but also excellent growth prospects in a transforming area.

It’s characteristics like that that underpin successful commercial property investments. But while there is growing excitement around commercial property’s potential to generate reliable income, particularly for those moving into retirement, few investors understand the real drivers of good commercial property investment. 
There are five features that help investors distinguish good commercial property investment or funds from the bad.

High-quality tenants

Quality tenants are the major building block of commercial property. You want access to high-quality tenants with deep pockets and fixed leases – whether government departments, Australian businesses or international companies.

The Connect Corporate Centre in Mascot has a list of high-quality tenants, including the Commonwealth Government, Kone Elevators, global real estate services firm Jones Lang Lasalle, former Qantas credit union Qudos, and international medical device maker, Boston Scientific.

The Fund’s portfolio more broadly consists of household names such as Coles, Woolworths, Leo Burnett, ConocoPhillips and Dulux.

High occupancy rates and a long rent roll

In addition to quality tenants, investors should look for properties and funds that have a high number of tenants. But, importantly, you should look for a high occupancy rate that has been demonstrated right through the cycle. A high occupancy rate allows the property or fund to maintain consistent cash flow streams.

Past performance is not a reliable indicator of future performance.

We have a good track record of renewing tenants and our occupancy rate has been more than 95 per cent for more than 10 years.

Maintaining high occupancy requires excellent management: making sure tenants are well taken care of and that we’re doing all we can to service them.

The right level of debt

Debt often plays a big part in real estate. Debt juices up capital returns – it multiplies both gains and losses. But debt can make income less secure. The right level of debt depends on your investment objectives. 

If you are looking for a defensive, income-generating investment, then you’re likely to prefer an investment with lower levels of debt underpinning more predictable returns.

Because we focus on a solid income profile with a little bit of capital growth, our fund’s policy is to use debt very conservatively. Our gearing levels are typically 0 to 15 per cent. 

Location, location

Just as with residential property, location matters. History shows that assets in major cities tend to benefit from a larger pool of tenants and industries, creating higher rental demand, strong underlying land values and more stable rental returns. 

The property should also be in an area with potential. We believe the Connect Corporate Centre’s location in Mascot provides significant upside to rents. The South Sydney market has been transformed over the past decade and Mascot is establishing itself as an attractive new commercial precinct.

Rents in Mascot at $360sqm to $400sqm are cheap relative to the CBD, which have risen from $600sqm to $1000sqm, but also relative to the likes of Chatswood, Parramatta and Macquarie Park. However, Mascot rents probably won’t stay cheap forever. As the area continues to change and densify, our view is that the market will catch up over time, providing solid capital growth.

Another recent acquisition, the Brickworks Centre, a 15,183 square metre single -level lifestyle centre at Southport on the Gold Coast, has 50 tenants across fresh food markets, eateries, furniture, homewares and boutique retailing.

The Brickworks Centre is located in Southport, a hotspot for population growth on the Gold Coast. Southport has been classified as a priority development area which has led to a surge in development applications including several mooted large-scale apartment projects. The Centre also benefits from the recently constructed light rail, built for the Commonwealth Games.

Scale and diversification

The final factor is diversification. Diversification is crucial to producing quality, stable returns from commercial property. Ideally, you don’t want to be exposed to one property with one tenant. If the tenant leaves and you have difficulty re-leasing, your income could dry up.

Few commercial properties are priced under $1 million, and it can be difficult to get the scale required to achieve a diversified exposure unless you invest in a fund. A fund provides diversification across national property markets, property sectors, buildings and tenants.

The Wholesale Australian Property Fund, as an example, has exposure to NSW, Queensland, Victoria, South Australia and the ACT. We are also diversified across retail, office and industrial sectors, which bring different benefits to a portfolio. Industrial, for example, typically generates more yield. (Broadly, we aim for one-third in retail, a third in office, and another third in industrials.)

We have a mix of 300 tenants in our 22 properties across many sectors such as retail, government, financial and business services and manufacturing and transport. 

Ideally, you don’t want to be overly exposed to one tenant. Our largest tenant, generates less than 5 per cent of the portfolio’s revenue and if we acquire further properties in the fund that percentage will fall. 

Locking in solid returns

There is no doubt that commercial property can deliver solid, stable income streams. But to deliver that stable income stream, investors need to focus on the right properties and right funds.

Our team is extremely selective and for every property we buy, we typically consider and reject another 20. 

If investors can focus on properties and funds that have good quality assets and tenants, then they will lay the platform for solid returns over the medium to long term. 

For more information on the Wholesale Australian Property, listen to our recent webinar.

It’s important to be aware that there are risks associated with investing in the Wholesale Australian Property Fund. Before investing, please read the Product Disclosure State which can be found by visiting our website.

Source: AMP Capital 12 October 2017

Author: Christopher Davitt, Portfolio Manager

Important note: Investors should consider the Product Disclosure Statement (“PDS”) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”) for the Wholesale Australian Property Fund (“Fund”) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. National Mutual Funds Management Ltd (ABN 32 006 787 720, AFSL 234652) (“NMFM”) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, NMFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance.

While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors and their advisers should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.

Mining and mining services companies are entering a new paradigm; propelled by advancing technology and artificial intelligence, the segment’s “path to payback” for some of its main capital expenditures is being cut in half in some cases, according to Dermot Ryan, AMP Capital’s Multi Asset Group, direct equities, portfolio manager.

The cyclicality of mining and mining services means companies in the segment predictably go through periods of capital expenditure, followed by periods of operational cash flow, before they’re able to return capital to shareholders and the process starts again.

The “path to payback” for major machinery such as trucks might have been anywhere between three to five years, depending on the company as recent as 2012, Ryan describes during AMP Capital’s recent Capital Insights Forum.

With “quite a few” mining services companies now investing in new technologies – such as automated trucks and other technological developments in the segment improving efficiency – the payback period for a mining truck in the Pilbara, for instance, is now more like 18 months, he says.

Quicker turnarounds on return on investments could help mining services companies in particular progress through cycles quicker, Ryan reckons.

This could mean getting a head start on their global competitors, which can help the local names secure a strong position at the bottom of the cost curve, which could in turn help protect profitability in the event of any pullback in commodity demand, Ryan adds.

The technological efficiencies miners are finding coincides with a resurgence in commodity prices and a return to capex for the sector.

“We’ve noticed the miners have done an incredible job on the cost out, and that’s probably coming to an end now. With the new capex coming through we’ll be looking for miners in general to hold their cost levels and expand their operations. This should be good for some of the listed mining services names,” Ryan notes.

Mining services led the capex this earning season, Angus Nicholson, AMP Capital’s investment strategist notes.

Source: Company Data, IBES Estimates, Credit Suisse Estimates

This is the first time in six years the ASX has seen an increase in capex estimates, Ryan highlights.

The increasing capex provisions have been clustered in energy and commodity-related sectors and in the mining sector reflected much needed replacement capex after a few lean years of investment.

“So these companies have done a marvellous job driving down their unit costs and are now looking to open a new mine or do some drilling to bring on the next stage of production or prove up reserves,” Ryan explains.

Ryan also adds this is a positive sign for the broader economy, which has been dogged by anaemic economic growth. 

“This is a positive trend for the economy and hopefully one that continues,” Ryan concludes.

Investors looking at the mining sector could expect to take advantage of dividends in the sector between now and the next earnings season, Ryan adds.

“The miners have come back from being in a precarious position and are now back to positions where they are able to pay out a large amount of cash flow. These are obviously cyclical dividends but they’ll be paying strong dividends now. And with the commodity uplift coming through the market, it should bode well good for next reporting season as well,” Ryan comments.

Source: AMP Capital 14 September 2017

Author: Dermot Ryan – Direct Equities Portfolio Manager

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

If you look around the world we face unprecedented risks. The Trump Presidency, North Korea’s nuclear ambitions, rising interest rates, and fully valued markets are all spot fires that could engulf portfolios.

These risks can seriously dent investor’s and client’s life savings, and damage their ability to reach important financial goals. The stakes are high.

Savvy investors and advisers are now actively looking to insure against those portfolio risks by using natural hedges like diversification and defensive assets.

Unfortunately, as you can see in the chart below, two big market events in recent memory – the 2000 tech wreck and the 2008 global financial crisis (GFC) – highlighted the limitations of diversification. Bonds were meant to provide a ballast against falling equities. But just when we needed protection the most, both fell at the same time (positive correlation).

click to enlarge

Source: Bloomberg, AMP Capital 2017

It was as if we’d bought insurance for our house and the insurer didn’t pay up.

In this risky market environment, investors and advisers need to look to other forms of portfolio insurance and protection, particularly options. 

Some investors and advisers think options are risky; but options reduce portfolio risk, like insurance on your house. The key is to use them in a dynamic, cost-effective way that minimises performance drag, like only buying insurance only when a fire or storm starts to threaten your house and when insurance premiums are cheap.

A simple contract

Options may seem complex, but basically they are a contract that is sold by an option ‘writer’ to an option ‘holder’. That contract gives the holder the right (but not obligation) to buy or sell a security, such as shares, at an agreed price on or before a specified date.

A ‘call’ option gives the holder the right to buy the underlying security; a ‘put’ option gives the holder the right to sell the underlying security. 

You can limit your trading to options themselves; you don’t have to trade the underlying security themselves. If the underlying shares fall, for example, your put options become more valuable. 

Of course, like any insurance, options cost. The holder must pay the option seller a ‘premium’.

Protection from puts

Put options are a great way to provide protection against market falls.

Buying protective put options are like buying classic insurance – you pay a premium upfront and it pays a positive return when the market declines. 

Source: Bloomberg, AMP Capital 2017

The put contract illustrated in the chart above has a strike 5 per cent below the market level. If the market falls 10 per cent, you will get a 6 per cent return. The premium is 1.5 per cent. If the market goes up or falls less than 5 per cent, the option will expire worthless and you lose the premium.

The cost of options

We buy insurance on our house all the time. Can’t you just hold protective puts all the time to protect portfolios?

Unfortunately, because options cost money (the premium you pay to the option seller) they drag on performance. 

Source: Bloomberg, AMP Capital 2017

In the chart above, you can see the impact on a notional $10,000 of rolling put options at 5 per cent below the money on the S&P500 in the US. There were positive payoffs to the left towards the GFC. But, generally, they are a drag on performance.

Most investors and clients are in accumulation phase. They can take short-term volatility, but they can’t take this drag on performance.

Prudent protection

The good news is that by using options selectively and dynamically, you can get portfolio protection without major performance drag. 

There are three ways to use options cost-effectively.

1. When it’s time

The first method is to only use options when your process or methodology says to reduce risk. For example, AMP Capital uses a Sentiment Score for its dynamic asset allocation (DAA) process, which informs our use of options.

2. When they’re cheap

Another is to buy options when they are cheap. Premiums you pay for options change depending on what the market expects volatility will be. If the market expects higher volatility in the future, people buy more options which pushes their price up. The VIX index measures the implied level of volatility. If the VIX is low, options are cheap.

3. Other markets

Another way to keep costs low is to buy options in countries outside the US. Put options are expensive in the US. Regulations give insurance companies a big incentive to buy put options on market exposures, mostly the S&P500. That pushes up the price of put options. So you should look at other markets, such as Europe and China, to buy protective puts.

Successful protection against Presidential uncertainty

At AMP Capital we successfully use options to protect against worrying market events. 

In September 2016, we were particularly concerned about the US Presidential election triggering a market correction. Our DAA process also showed added risks from record low yields and high valuations in the S&P500.

So for relevant portfolios we entered into a more complex options strategy, called a ‘reverse collar’ to protect against a possible correction.*

Click to enlarge

Source: Bloomberg, AMP Capital 2017

As shown in the chart above, we entered the position in early September, a good time. The market continued to be volatile along with the polling of the candidates. The market fell almost 5 per cent (close to the maximum payoff) and we exited the position when the majority of the potential gain from the strategy had been captured. 

This example also highlights one of our key rules: each option must have pre-defined exit triggers so we crystallise the benefit (or loss) in a disciplined manner.

Incorporating options into strategies and decisions

Portfolios that hold different types of assets, such as multi-asset funds, obviously have an inherent level of risk protection because they have a diversified range of assets. 

But as we’ve seen, diversification doesn’t always deliver portfolio protection, particularly during extreme market events. Sometimes we need to turn to other forms of insurance and protection, such as options.

With the world facing significant geopolitical, economic and market risks, advisers and investors should be considering incorporating options as an insurance strategy. 

Advisers and investors should also be seeking out investment managers who have the skills to use options in a cost-effective and disciplined manner so they can maximise protection and minimise performance drag.

*A reverse collar is selling (short/writing) a put option and buying (long) the call option on the same index. At the same time, to cover any negative market movement and therefore the short put, we sell the same face value of the contracts short, with futures contracts in the S&P500 market.

A reverse collar takes advantage of skew in the US options market. Because of the previously mentioned insurance regulations, puts are more expensive than calls. The skew means we get protection (positive payoff) for the first 5 per cent of the market decline. And we only give up around 2.3 per cent of the upside if the market rallies.

Source: AMP Capital 14 September 2017

Author: Heath Palos, Assistant Portfolio Manager, Multi-Asset Group

Residential property has become the new religion in Australia. The buoyant market, particularly in Sydney and Melbourne where house prices have jumped 75% and 50% respectively in recent years, means residential is constantly talked about and analysed. 

But as more and more baby boomers move into retirement, there is a growing need to seek investments that provide reliable income streams and protect against the unique risks they face such as inflation.

So long as Australians associate ‘property’ with ‘residential’, there is a danger they will ignore commercial property — an asset class that has historically delivered the very stable income, defensive attributes and potential for solid long-term gains that retirees require today. 

More Australians, particularly retirees, therefore, need to start looking beyond residential and understand the 5 key advantages of commercial property.

1. BULK OF RETURNS FROM INCOME

The first advantage of commercial property – retail, industrial and office – is that income underpins commercial property as a great investment. Over the past 30 years, commercial property has delivered total returns of 9 per cent a year. In general, some 2 per cent of the total return has been capital growth. The remainder 7 per cent is income – that’s more than double the standard term deposit rates, albeit with more risk.

By contrast, capital growth dominates residential returns. If we use a three-bedroom home in Sydney or Melbourne as proxy, residential property delivered a greater total return over the past thirty years. However, some 7 per cent of the total residential return was capital growth. That left income at just 3 per cent.

2. A STABLE INCOME SOURCE

Importantly, the income investors earn from commercial property is stable. Tenants, such as businesses and government, lease buildings generally for between 3 to 10 years, sometimes longer. Those long-term leases provide income security.

For example, our Wholesale Australian Property Fund acquired the Codan Building, a campus-style facility in Adelaide suburb of Mawson Lakes for $32.1 million in March this year. The building is fully leased to Codan, an ASX-listed company with a strong track record. The tenant signed a new 15-year lease that started in December 2015 with a 10-year option, and the property provides an initial income return of over 7.5 per cent.

Residential tenants, however, typically sign up for just 6 to 12 months, and in most states they can break that lease with 8 weeks’ notice. 

Within commercial property’s longer leases are fixed escalations in rent – each year rents are increased at an agreed rate of around 3 to 4.5 per cent.

There is also much less chance of a commercial property being damaged by a rogue tenant.

3. PORTFOLIO DIVERSIFICATION

Commercial property also has a low correlation to equities, which makes it relatively stable when markets are volatile.

Firstly, the market prices commercial property funds based on valuations which mean a lot of the day-to-day volatility is smoothed out, both relative to the equities market and even relative to listed property options.

Secondly, in a downturn total property returns can fall hard and dramatically, but the income from commercial property is less impacted in the short term because of legally binding leases. Because they have signed up to long-term rental agreements, the tenant must keep paying their rent each year, regardless of whether their profits rise or fall.

That low correlation to equities, and relative stability, means commercial property provides excellent portfolio diversification and some protection from downside risk.

4. INFLATION HEDGE

Additionally, commercial property is an excellent hedge against inflation, one of the biggest risks for retirees. When inflation accelerates, price rises flow through to higher profits, and in turn that flows through to higher rents and rising land values for commercial property. Historically, commercial property values have tended to rise at rates similar to inflation. That relationship has held for a very long time.

Commercial property therefore provides protection against an unexpected inflation spike. These spikes can have a double-whammy effect on retirees: not only does the price of day-to-day items such as food go up, but core defensive assets such as government bonds suffer.

Commercial property preserves the ‘real’ (after inflation) value of a retiree’s portfolio, allowing the income returns they generate to grow at a similar rate to the cost of living.

5. STRONG RETURN OUTLOOK

And finally, commercial property also offers a solid return outlook. 

We have seen commercial property prices rise in recent years. Investors have been attracted to the sector’s yields in a low interest rate environment. Given our view that interest rates are set to remain low over the medium-term (the next three years or so), we believe that trend has further to run.

Overall we expect commercial property to deliver a 7-8% total return over the medium term, with about 5-6% in income and the remainder in capital growth. That outlook is based on deals we are seeing and executing, where commercial property is being valued and sold on the expectation of a 7 to 8% return.

Looking beyond residential

When we look around at other sources of income and asset classes, the outlook for returns from commercial property is excellent.

Cash and term deposits are no longer adequate sources of income, and The Reserve Bank is unlikely to raise rates aggressively any time soon. Traditional asset classes such as stocks and bonds face the large-scale challenges posed by both slowing global economic growth and historically low interest rates.

Geopolitical tensions, such as North Korea’s missile program and China’s territorial dispute with neighbouring countries over the South China Sea, is instilling further uncertainty in financial markets.

While residential property has been strong, and a crash is unlikely, its growth is now moderating.  Combined, the solid returns, stable income, and low correlation to equities that commercial property offers makes it an extremely attractive investment for Australians, particularly retirees seeking reliable income streams and protection against sequencing and inflation risk.

It’s time for Australian investors, particularly retirees, to look beyond residential and consider investing in commercial property.

Upcoming webinar

Join Christopher Davitt, Fund Manager for the AMP Capital Wholesale Australian Property Fund as he provides an update on the Fund and discusses recent properties that have been purchased. Tuesday 19 September 2017, 2pm-3pm. Register now.

It’s important to be aware that there are risks associated with investing in the Wholesale Australian Property Fund. Before investing, please read the Product Disclosure State which can be found by visiting our website.

Source: AMP Capital 14 September 2017

Author: Christopher Davitt is Fund Manager for the AMP Capital Wholesale Australian Property Fund and Australian Property Fund.

Important note: Investors should consider the Product Disclosure Statement (“PDS”) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”) for the Wholesale Australian Property Fund (“Fund”) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. National Mutual Funds Management Ltd (ABN 32 006 787 720, AFSL 234652) (“NMFM”) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, NMFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance.

While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors and their advisers should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.