Is it worthwhile to invest in defensive Managed Funds or ETFs?

I hope you are going well and welcome to Finance and Fury – In this episode we go through the second part of a question from David – that is: Are the cash assets that held in managed funds or etfs equivalent to holding cash in the bank? If so, instead of investing in defensive/conservative funds, wouldn’t it be better to just invest only a portion of your money into high growth funds/etfs and leave the rest in a bank? At least then, if you hit hard times, you wouldn’t be forced to sell fund units/etfs in a (potentially) down market.

In this episode – We will look at how managed funds/ETFs operate – look at the cash equivalent funds – then look at allocations based around your goals – as well as the opportunity cost of investing in defensive funds – so a fair bit to unpack

1. What will be discussed in this episode is not advice – just my personal thoughts about investment allocations and some general information on cash funds and the opportunity cost of holding these

First point is that you should never invest anything that you may need in the short term anyway – Good idea to have savings to cover at least 3 months of a lost income – or 3 to 6 months to cover expenses – doing this this reduces the chances of needing to sell down investments to cover any emergency funding

2. Also – avoiding needing to sell at a loss comes down to allocating funds – In a multi-asset manager that holds a mix of growth and defensive allocation vs single asset classes can avoid a situation of selling when some of the assets are down

But let’s say that you have enough savings to cover 3 months of expenses – the opportunity cost of investing in investments that hold cash comes down to if you have a mortgage or not –

1. If you have a mortgage – then investing in defensive funds can make less sense than if you don’t
2. Why? The interest saved on a mortgage in the current environment is likely greater than the income that you can generate through a cash fund – we will go through this point further throughout the episode – but it should be noted that if you can save 3% in interest expenses on a non-deductible mortgage, this is better than investing in a cash fund that may generate you a 0.5% interest return – this if for two reasons:
   1. First – Tax – even though the income return you may get at the moment is small – that interest return would be added onto your taxable income – reducing the return further
      1. If you get a 0.5% interest income on a TD – this after tax can be as low as 0.24% if you are on the highest marginal tax bracket – therefore, any personal cash investments have a lower net return due to the pure income component after tax – at least with growth you don’t need to pay any tax on this until the gain is realised
   2. Second – Saving has the same effect as earning on your cashflow – every dollar that you can save is a dollar that can be reallocated towards a financial goal – and if you can save money, this has the same net effect on your cashflow as if you had earnt those funds
      1. Say you save $12,000 p.a.– this translates into $360 in saved interest costs on your normal repayments assuming a 3% interest rate – this then reduces down your minimum repayments by this level, which means that your cashflow is better off – which is the same as earning a pre-tax income from $360 to $680 depending on your MTR
      2. You then have the option to put this towards further debt repayment, or alternative wealth accumulation such as salary sacrifice or personal investments
   3. If you don’t have a mortgage – then this can sway your decision towards opening an investing into defensive funds
      1. This all should come down to your individual goals – what do you want to achieve?
      2. Are you wanting to build a home deposit and are a first-time home owner? Well, there are better schemes to save towards this, such as the first homeowner superannuation saver scheme – as your get a better deemed rate than the cash rate and can in a tax effective manner – as long as your MTR is above 34.5%
      3. Are you just wanting to invest and reduce your volatility potential? Then it may be the case that investing in defensive funds in conjunction with higher growth investments may still be appropriate – more on this later

To get into the real meat of this question – it comes down to Investment Allocation of the funds that you are investing in – Cash equivalent managed funds or ETFs – these provide a defensive allocation versus high growth investments – But it is important to be aware of how a managed funds/ETFs operates

1. every fund beyond an index fund that is 100% invested will always hold cash – this is for liquidity requirements and flexibility
   1. Generally – in a fund mandate – it allows the manager to hold 0-20% for cash investments, This is for the purpose of having liquidity to meet redemption as well as distributions – in addition to having cash build up from profit taking from selling shares, or holding cash to wait for a buying opportunity
   2. Say you buy an Aus or Int managed fund or ETF – and these are active managers – then you will be holding a portion of cash per unit that you have in this fund – normally share funds hold around 5% of cash on average – but can be higher or lower depending on the market conditions
2. But obviously some defensive funds have higher allocations to cash – these funds can go up to 100% if it is a cash equivalent fund –
   1. These sorts of funds invest in term deposits and sometimes treasury notes with 90-day maturities so that they aren’t overly impacted by interest rate dropping the price of the asset
      1. The returns for these funds are on average around 0.5% to 0.2% for the past year – and around 3% p.a. over the past 5 years
      2. This return is probably higher than an at call cash account that you can get with a bank – but is it worth it?
   2. For some it may be – but this return has been around 0.1 to 0.2% beyond what you could get through a term deposit – so on $100k this would be an extra $200 pre tax
      1. if you have no debts and are saving for an upcoming expense outlay, like a holiday or renovation, then due to cash being a medium of exchange, this is probably the best method to achieve this goal
      2. but is this the best option if you are investing for the long term, and what is the opportunity cost? This is the foregone next best option
      3. For those that have a mortgage – it would probably be better to allocate funds towards an offset account or additional debt repayment than it would be to invest in a cash fund
         1. Due to the nature of how banks work – you will always get charged a higher interest rate on debt than what you can earn form interest – plus after tax this reduces down your returns further
         2. I view cash as a medium of exchange – not an investment – it can be used to pay down debt, save for upcoming expenses which require the exchange of cash for a good or service, or be converted into a long-term wealth accumulation investment

I came to the realisation over the past few years, in particular when we have been in a low interest rate environment – allocations should be made to where they best serve your interests –

1. Allocations of cash and bonds are all well and good for some people – but compared to interest rate costs for debt, you have a guaranteed savings through repaying additional debt –
   1. But the opportunity cost comes into this – Especially versus returns from high growth share allocations –

Let’s look at an example for asset allocation – in a situation where you have a mortgage

1. Mainly looking at a balanced Allocation and then that of a 100% growth allocation – this is where the loss from a total portfolio is dependent on where it is invested – and the idea of having more defensive investments is to reduced the volatility in your portfolio
   1. Example – say you invest your money in 30% defensive vs 70% growth – Investing $100,000 in total but $30,000 is invested in defensive funds – say this is a multi-asset managed fund
2. Let’s say the market tanks – and your shares drop by 30% which is your growth allocation – your $70,000 in shares would now be worth $49,000 – lets assume that bonds don’t move – so in total your portfolio is worth $79,000 including the defensive allocation – this is a loss of 21% – so the total loss as a percentage is less than the share market decline – but you have still seen a reduction in your portfolios value of $21,000
3. Instead – let’s look at a different situation – where say that you invested only $70,000 in 100% high growth investments, being purely shares – the market drops by 30% – then your portfolio is now worth $49,000 = which is the loss of 30% – but you have still lost $21,000 in value
4. In both scenarios – the nominal dollar loss is the exact same, but it is just the percentage movement that is different – one is a loss of 21% whilst the other is 30% in total value of the portfolio lost
5. This brings up the question, and comes back to the concept of opportunity cost – would this $30,000 in defensive funds been better off elsewhere?
   1. If you have a mortgage, it may have been – as this could save you $900 in interest, which when included in your total portfolio returns with the share decline, results in a loss of 20%
   2. Now this is all assumptions based, and hypothetical = but this sort of thinking can be used as hypothetical examples to increase your tolerance to losses on your investments – if you reallocate funds towards debt repayment instead of a defensive investment, this can almost be thought of as the same as a balanced allocation
6. Also introduces a strategy of opportunistic investments – Buy into the market when it drops by a margin of more than 12 months’ worth of returns – into the higher growth investments – essentially you are converting excess savings into investments

Long term – higher growth investments should provide greater levels of capital growth above what defensive can provide – but in the short term it can certainly provide a negative return

1. This Is where I believe in allocating funds based around goals/your needs – All investing should come back to what you Needs from investments are – I look at goals-based investing – what allocation meets the desired returns from each allocation –
   1. If you need savings to cover expenses or as an emergency fund – then save these in cash, in a savings account or an offset if you have a mortgage
   2. If you need long term wealth – then you can choose to invest in a well-diversified portfolio of shares
2. For me – my defensive funds come in my offset account – build savings inside this account – plus make some additional repayments on the mortgage to pay this off – Beyond this – which I see as my defensive allocation – as I can draw on the offset or redraw on the loan if the worst happens – everything for me goes towards high growth investments on a monthly basis
3. In some cases, it will be worthwhile to invest in defensive funds – If you are retired and have no mortgage – and you are adverse to large swings in the value of your portfolios value
   1. Personally – I have no defensive investments – they are all higher growth Aus shares, or managed funds in specialist funds – My defensive allocation is additional repayments on my bad debts – this won’t be right for everyone –

In summary = you need to consider the opportunity cost of any investment –

1. Holding at least 3 months of expenses in cash is important – but beyond this what do you do with your cash?
   1. If you have a mortgage you can choose to instead of invest in defensive funds, allocate funds to this and then less to higher growth investments – this can increase the volatility of your portfolio
2. Plenty of people are focused in the percentage returns and not the dollar value returns –
   1. but if you have a mortgage, it may not make sense to invest anything into defensive funds
   2. If you don’t have a mortgage, and are just saving cash, the difference in returns between a savings account and a cash fund would be a fraction of a percentage

Thanks for the question and thanks for listening