REITs and high conviction funds

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Question 1: What is a high conviction fund?

Answer (by Ron Bewley): It is a term often used but less often defined. My view is that it is a fund of quality stocks that can be left unmonitored for periods of time – usually without tinkering. There are no speculative stocks – from exploration nor corporate actions – in a high conviction fund. Importantly, a drop in price of one or more stocks is more likely to attract attention for any spare cash rather than a cause for abandonment!

I have my own rules for assembling a high conviction fund. At times like the present, I would advocate eight to 15 stocks, if equally weighted, but more if some stocks are given less weight. There are ways of determining the equivalent number of stocks for general portfolios. In more turbulent times – such as 2008 to 2010 – the optimal number of stocks is more like 12 to 20, and possibly more. I have papers in the Switzer Super Report and my website woodhall.com.au on these and many more associated issues.

I determine how much weight should be given to each of the 11 major sectors using my quantitative methods. Then, I allocate an appropriate number of stocks for each sector based on the size of the sector and the quality of the component stocks. Care should be taken not to have too much exposure to any one stock. Only companies from the ASX 100 belong in a high conviction fund in my world.

When I assemble a new portfolio, I only choose stocks with a ‘good’ consensus rating from brokers as published by Thomson Reuters. With ‘1’ for a buy and ‘5’ for a sell, I would only ‘buy’ a stock with a 2.5 or better. However, I would not sell unless the ratings fell well below that number. I have rules.

I like to think of rebalancing a ‘high conviction fund’ either once or twice a year. Rebalancing any more often is a sign of a trader’s spirit.

Question 2: I am currently contemplating selling one of my two Real Estate Investment Trusts (REITs) in favour of investing in an Australian income-oriented managed fund. I hold Aspen Parks and Cromwell Phoenix. Aspen Parks won’t be able to be sold until early 2014. Although paying a good 8%, it has lost growth and only paid a net 2% or so in the last year. Cromwell Phoenix has been better at about 11%. I am in the pension phase of my SMSF, but still working and making $35,000 per year tax super contributions. Do you think a good income managed fund will outperform an REIT in 2013-14?

Answer (by Paul Rickard): REITs (Real Estate Investment Trusts) as a sector did pretty well in the early part of 2012/13, however have recently come off the boil. To 31 July, the sector is up 4.9% this calendar year, compared to 8.7% for the market overall.

This is not overly surprising since there is really no growth in commercial, office or industrial rental returns. In fact, vacancy rates have been increasing – reflecting the subdued nature of the Australian economy.

As interest rates have come down, REITs have become more attractive on a relative yield basis, and been bid up in price. This downward move in interest rates is almost over.

In the next 12 months, I don’t think you are going to see much capital appreciation in the price of REITS. You probably can expect a running yield of around 6% to 7% – and this is going to be reasonably attractive to some investors.

Personally, I am going to stay underweight the REITs sector (it is also not tax advantaged for a super fund).

As to your question, it really depends on the ‘income managed fund’ and what capital risk the fund is taking. If the fund is investing in high quality securities (with very limited credit risk), then you are probably going to do better (in terms of income return) from a REIT. If the fund is investing in securities or assets of lower credit quality with greater risk of capital loss, then the income return is going to be higher than that for a REIT.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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