Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Sharemarket fuel for economy or casino?

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Michael Hill International chairman Sir Michael Hill is among a handful of individuals who still dominate NZX-listed companies.
Michael Hill International chairman Sir Michael Hill is among a handful of individuals who still dominate NZX-listed companies.

Significant shift from family ownership to institutional control of listed companies in recent decades has changed market behaviour Share ownership has privileges and obligations. One of the obligations is to ensure that the interests of shareholders are not eroded by the interests of management.Are sharemarkets investment or speculation?

Do they supply fuel to power an economy or are they just legalised casinos as some critics claim?

This column believes that sharemarkets make a very important contribution to economic growth and prosperity but they are constantly evolving and a number of recent developments have casino-type characteristics.

Many of the early successful businesses were family financed. These companies listed when they needed to raise money to expand or have a transparent market for family members who wished to sell shares.

A few decades ago the NZX had a large number of former family owned companies including Alex Harvey, Carter Holt, Fisher & Paykel, Fletcher, L D Nathan, Lane Walker Rudkin, McConnell Dowell, Owens, Pyne Gould Guinness, R&W Hellaby, Turners, Wattie and Yates.

After sharemarket listing these companies were predominantly owned by new retail investors and family members. Institutions played a relatively minor role in most countries, including New Zealand.

For example 60 years ago individuals owned 92 per cent of US-listed companies and institutions just 8 per cent. Individuals now own only 30 per cent and institutions 70 per cent. There has been a similar trend in most western countries.

Annual meetings, which were much more widely attended than they are now, reflected the dominance of family and individual shareholders. These meetings were fairly informal, addresses were not released to the stock exchange and the after-meeting social functions were lively.

AWF Group, Briscoe Group, Colonial Motors, Delegat's, Michael Hill International, Rakon and The Warehouse Group are the only large NZX companies that are still dominated by an individual or family.

Rakon is a standout example of a company that has failed to make a successful transformation from family ownership to stock exchange listing.

The biggest sharemarket changes in recent years have been the massive increase in funds managed by institutions and the emergence of passive funds, particularly Exchange Traded Funds (ETFs).

The first development has been relatively slow in New Zealand because, up to October 1, 2007, unit trusts or pooled funds were subject to a full capital gains tax whereas individually managed money was not. Therefore there was a big disincentive for individuals to invest through unit trusts or managed funds.

However, institutional influence has increased since the introduction of Portfolio Investment Entities (PIEs) and KiwiSaver regimes in October 2007. As long as these two schemes remain intact then institutional shareholdings of NZX-listed companies will continue to increase in the years ahead.

Individuals tend to buy and hold whereas institutions have a stronger short-term orientation, mainly because their performance is measured and scrutinised on a monthly bias. Thus, many institutions have a clear trading bias which has been facilitated by their ability to negotiate extremely low brokerage fees with sharebrokers.

The volume of share trading has increased substantially over the past few decades, particularly in the United States.

Daily trading volume on US stock exchanges has surged from just 2 million shares in the early 1950s, when markets were almost totally dominated by individuals, to over five billion shares per day in recent years.

In the early 1950s the annual value of all share trades was equal to just 15 per cent of the total market capitalisation of United States sharemarkets. This expanded to 35 per cent in the mid-1960s, 100 per cent in the late 1990s and now exceeds 200 per cent.

The massive increase in share activity has been facilitated by computer-generated trading and low brokerage rates. High-frequency trading (HFT) now represents up to 50 per cent of total Wall Street trading volume. Some of these HFT investments can be held for less than 60 seconds but they provide additional market liquidity that benefits long-term investors.

Share trading volume is far more modest in New Zealand and has remained at just under 50 per cent of total market capitalisation on an annual basis even after the introduction of the PIE and KiwiSaver regimes in 2007. However, NZX share trading volume is expected to grow as KiwiSaver expands and institutional shareholdings increase.

As share trading volume increases, the mix between the total value of all shares traded on markets and the total amount of new equity raised through IPOs, placements and rights issues has changed.

For example, in the United States share trading activity represents over 99 per cent of the total value of stock exchange activity and new capital raisings less than 1 per cent.

The balance is slightly more even on the NZX, which had share turnover of $30.3 billion in 2012, or 90 per cent of total activity, whereas new capital raisings were $3.3 billion or 10 per cent of activity.

The other major changes have been the massive increase in futures and derivatives and the huge growth in passive funds, particularly Exchange Traded Funds (ETFs).

In recent years trading in S&P500 Index futures has exceeded US$60 trillion ($74 trillion) per annum or over five times the total value of all companies included in this index while the notional value of all US derivatives exceeds US$700 trillion.

Since 2004 assets held in US passive funds - excluding ETFs - has soared to US$1.3 trillion, from 12 per cent of all equity funds to 21 per cent.

In addition ETFs are worth a further US$1.5 trillion and are forecast to reach US$3.5 trillion in five years.

The problem with passive funds is that they don't invest in IPOs because they can only purchase shares in index companies and most companies have to be listed for some time before they are included in an index. This accelerates the imbalance between the value of sharemarket trading and new capital raised.

Short-term trading and passive funds also interfere with the important link between corporate owners and corporate managers.

Share ownership has privileges and obligations. One of the obligations is to ensure that the interests of shareholders are not eroded by the interests of management.

Short-term traders, particularly those employing computer generated trades where buy and sell orders are executed within 60 seconds, have no interest in monitoring management. Passive funds, which are essentially long-term holders, should play a role in corporate governance issues but these are low-cost funds that don't have the resources to commit to corporate governance.

Although passive funds are long-term holders they can generate speculative short-term activity.

For example, Kathmandu's share price rose to $3 in anticipation that the company would be included in the ASX200 Index, but plunged 25c to $2.75 on Friday last week when investors realised the company was not going to be included in the index.

Inclusion in the index would lead to buying activity by passive funds.

As nothing changed as far as Kathmandu's operating performance was concerned, the company's share price movements were a case of speculative activity dominating investment considerations.

Short-term profit guidance figures also stimulate share trading activity, particularly as most companies are extremely reluctant to give any indication of their medium or long-term profit growth potential.

Although there has been a substantial increase in sharemarket trading activity over the past few decades it can still be argued that investment considerations remain far more important than speculative activity, particularly in New Zealand.

This increase in share trading activity can be viewed as positive as it has created more liquidity for longer-term investors.

It is important that investment considerations continue to dominate, particularly as far as corporate governance monitoring and IPOs and other capital raising activities are concerned.

Futures, derivatives, computer generated trading and ETFs have an important role to play as far as market liquidity is concerned. However, it is important that these products and developments don't completely dominate sharemarket activity. Brian Gaynor is an executive director of Milford Asset Management.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

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