Brent Sheather: Study's iwi trust predictions aren't clear cut

Grandchildren will benefit from growth in perpetual trust investments. Photo / Getty Images

A new study comparing the investment strategies of intergenerational trusts predicts that iwi trusts will increase their asset base from $1.4 billion today to $21 billion in 2060. However, this forecast assumes compound returns after fees and inflation of 9.6 per cent a year, almost three times the long-term rate of return expected from international equities by various experts.

The report in the September Journal of the Institute of Finance Professionals New Zealand was produced as part of an MBA programme at the University of Auckland.

It draws a series of conclusions as to future growth based on what appears to be an inappropriate extrapolation of historic returns, short-term performance data in some cases, and may have confused arithmetic with geometric returns. The analysis also appears to ignore the impact of fees. Combined, these issues have the potential to materially alter the conclusions of the study.

The main point of the study is that community trusts such as the ASB Community Trust and the Canterbury Community Trust appear to use markedly different asset allocation strategies to those employed by iwi trusts such as Ngai Tahu, Tainui and Ngati Whatua.

This is a big deal because all of these trusts should be investing for the ultra long-term as they have the objective of providing for current and future generations of beneficiaries. These trusts are thus known as perpetual or intergenerational trusts.

The MBA study concludes that the typical asset allocation profile of community trusts, with a 40 per cent or so weighting in bonds, is too conservative and will result in marked long-term underperformance.

The study appears to have got to this 9.6 per cent a year after-fee rate of return figure by comparing the historic returns of equities with bonds, highlighting that equities historically have outperformed bonds, then erroneously assuming they will do so in the future by the same magnitude.

Various studies in the US and UK have shown this sort of simplistic analysis is incorrect. For example, an article in the Financial Analysts Journal in January 2002 by Robert Arnott and Peter Bernstein concluded that shares outperformed bonds over the past 75 years largely because of a number of non-recurring developments.

They determined future returns were likely to be much lower because the variables that determine returns are markedly different today. Chief among these is that the dividend on shares today is less than half that in 1926.

As we know, the return on shares equals the dividend yield plus the rate of growth. The dividend yield on US stocks today is about 2.5 per cent, in 1926 it was about 5.5 per cent.

Similarly the 2009 Credit Suisse Global Investment Returns Yearbook reckons that international shares will outperform bonds by just 3 per cent a year in the next 100 years versus an historic outperformance of 5.1 per cent a year. Both of these analyses suggest around 7 per cent a year is what we can expect from international shares long term, pre-fees, pre-inflation.

Historic returns are made further irrelevantas shares have become much more expensive over the period, as evidenced by the lower yield. Potential returns from an asset are diminished asit becomes more expensive.

The other issue the MBA study appears to have missed is the impact of management fees which, depending on asset class, can reduce returns between 1 and 3 per cent a year. The significance of this in comparing community trusts and iwi is that a high-quality, local bond portfolio requires relatively less in management input than equity.

So with prospective returns from international equities at around 7 per cent before fees, is the action of community trusts in overweighting local bonds paying 6 to 7 per cent a year with minimal leakage to fees and low risk so irrational? Perhaps not.

Later the MBA study seems to recommend a much higher than usual weighting in esoteric asset classes, such as hedge funds and private equity, on the basis that this is what the endowment funds of Yale, Harvard, Stanford and Princeton have done. What the report does not highlight is that these asset classes require expert management, attract much higher fees and, incidentally, also seem to be rapidly falling out of favour with some institutional investors overseas.

The historic comparison between bonds and equities is also made less relevant because the MBA benchmark group invests in developed country global bonds yielding 3 to 4 per cent, whereas community trusts have a large New Zealand bond bias and local quasi-government bonds offer yields of 6 per cent and higher.

The report uses the historic asset allocation of the endowment funds of Yale, Harvard, Stanford and Princeton as its "this is how it's done" benchmark. These endowments have in the past achieved high historic returns by exploiting valuation anomalies and illiquidity premiums in various asset classes such as commodities, private equity and hedge funds.

Whether this model will work in the future for iwi is debatable. But what we can be sure of is that it hasn't worked at all well for these endowments in recent years.

We can be similarly confident that, while many of these asset classes were cheap 10 years ago, with every man and his dog adopting these strategies the weight of money will diminish returns in the future.

The New York Times apparently reported that Yale achieved 8.9 per cent, in weak US dollar terms, over the past 10 years. In the same period a "dumb" index investment in New Zealand shares would have returned around 7 per cent in NZ dollar terms but returned 17 per cent a year, again in US dollar terms.

While hard data on these asset classes is hard to come by, there is one other fact that is particularly robust - these strategies cost heaps. The typical management fee for hedge funds and private equity is a 2 per cent annual fee plus 20 per cent of returns above a certain level.

While historic returns for some private equity and hedge funds have been excellent, successful investment is often a matter of firstly knowing which managers are skilled, and then being able to get access to them. Both issues are problematic, prompting one cynic to write in the Financial Times that he wouldn't invest in any hedge fund that he was able to get access to.

Certainly recent returns from these sectors have been horrid. A report on private equity entitled "Private Equity, Public Loss", by the UK Centre for the Study of Financial Innovation, was particularly scathing about the sector, highlighting inconsistent valuations, a lack of value-add, a dependence on gearing for performance, excessive fees and, indeed, questioned whether returns from private equity have exceeded those available from the share market.

Similarly the London Financial Times reports that hedge funds are losing popularity with institutional investors because, while they are the most expensive item on the investment menu, they have been producing returns almost identical to ultra low-cost index funds comprising 60 per cent equities and 40 per cent bonds.

Brent Sheather is an Auckland financial adviser and his adviser/disclosure statement is available on request and free of charge.