Personal finance and investing columnist at the NZ Herald

Brent Sheather: Dollar each way over risk factor

As grim as today's economy sounds, Germany survived World War II and the destruction of the Reichstag, its former seat of government, and will come through this crisis in Europe. Photo / Supplied
As grim as today's economy sounds, Germany survived World War II and the destruction of the Reichstag, its former seat of government, and will come through this crisis in Europe. Photo / Supplied

Investors don't need to be told that the prevailing mood in the financial markets is one of nervousness and fear, punctuated by occasional days of euphoria.

No one knows what the end game for Europe will be but we need to keep in mind that whatever happens France and Germany will still exist and the scenario facing those countries today is a lot better than was the case in 1945, and they survived that.

Perhaps of even more significance, however, is the uncertainty associated with the deleveraging of governments, banks and consumers. Austere times are coming for almost everyone and for many they are here with a vengeance.

The best indication we have of the future is the very low bond yields on extra long dated bonds in the United States.

At around 2.0 per cent for 10-year treasuries, the bond market is saying that we can expect an extended period of low or negative growth and inflation.

The question we have to answer as investors is whether these tough times have been adequately factored into bond and share prices or not.

Popular financial market terminology is to label days when investors are optimistic and buy shares as a "risk on" day. Days when bonds are popular are "risk off" days. So will 2012 be a "risk on" or "risk off" year?

Backing the "risk on" scenario are various fund managers who point to the low valuations of the US stockmarket based on forecast profits and the fact the latest measures of US economic growth are indicating a recovery is under way.

In the "risk off" corner are a number of independent economists and academics who argue that with governments and individuals paying off debt spending will be greatly reduced which is bad news for profits and thus share prices. Such an uncertain time and the extremely negative scenario implied by US 10-year-bonds suggest that retired investors should keep a higher than usual weighting in low-risk fixed-interest investments.

So, looking back at 2011 what did all the volatility mean for Mum and Dad investing with a financial adviser, contributing to a pension fund or investing in a balanced KiwiSaver fund? Assuming the typical asset allocation of 40 per cent in bonds and 60 per cent in growth assets and, most importantly, that performance matches the benchmark in each sector, the average balanced fund will have increased in value by about 1.9 per cent in the year, before fees and tax. Fortuitously the very poor returns in the stockmarket were more than offset by an extraordinarily good year for bonds. In bad times, low-risk bonds go up in price as investors flock to safe havens. This drives down interest rates which pushes up bond prices.

With numerous natural and manmade disasters 2011 was an excellent environment for low-risk bonds. Accordingly NZ government bonds returned 13.3 per cent in the year and global bonds returned 8 per cent. So while international shares fell by 5 per cent and Australian shares, with their resource focus fell by 10.5 per cent , this negative impact was more than offset by the good performance of bond portfolios.

In addition the NZ stockmarket managed to eke out a 1.4 per cent gain and the listed property sector, which commonly comprises 10 per cent of balanced portfolios, came to the party with an excellent 11 per cent total return.

If we weight these returns by the typical loadings in a balanced portfolio we get a 1.9 per cent return before fees and tax which is not good but not a disaster either. That's the good news, however unfortunately, these numbers may dramatically overstate the actual performance of the typical Mum and Dad portfolio managed by a financial adviser. For various reasons financial advisers tend to advocate higher yielding risky bonds rather than government bonds and in bad times, like we are in now, the bond market bifurcates - low-risk bonds go up in price, higher risk bonds go down.

While all the hype has been for emerging markets in the last few years, 2011 was not a good year for that sector and, consistent with a "risk off" predilection, emerging markets had a very poor year falling by a worrying 19.2 per cent. Predictably European emerging markets were the worst performer, down 25 per cent although Asian emerging markets at -18 per cent weren't far behind. In contrast, major developed markets fared much better with the US stockmarket actually up 1.9 per cent over the year and the UK down just 2.6 per cent.

The divergent performance of developed and developing markets in 2011 underline the fact that while the long-term fundamentals of emerging markets are positive they are highly volatile and produce minimal income so shouldn't feature too prominently in retired investors' portfolios.

Every year there is usually one aspect of investment strategy which stands out as particularly impacting retail investors portfolios in the previous 12 months.

In 2011, when low-risk bonds were the best performing asset in many of the major western economies including the US, UK, NZ and Australia, anecdotal evidence would suggest that many local Mum and Dad portfolios missed the boat.

In the course of my work I see many retail investors' portfolios and many of these have poorly constructed fixed-interest components in that they are often dominated by low-quality, unrated bonds and are inevitably too short term.

Both of these factors were particularly important last year because high-quality, long-term bonds did really well and low-quality, unrated bonds did not. An extreme example of the first category was 30-year US government bonds which, despite being almost universally condemned as a bad investment at the beginning of the year, actually managed to return a stunning 34.3 per cent. Yes, that is 34.3 per cent in a year, quite a nice surprise for someone who bought in January 2011 expecting to achieve the then yield of around 4.3 per cent. What happened? Yields fell to around 2.9 per cent and the price accordingly went through the roof. At the other end of the performance spectrum an example of lower quality bonds are the Goodman Fielder 16/5/2016's which seem to be widely held by retail investors.

In the quarter the capital value of these bonds fell by 2.8 per cent as the yield on these bonds rose from 6.9 per cent to 7.6 per cent.

In the quarter the capital value of these bonds has fallen by more than the NZ stockmarket at precisely the time that their diversification benefits as bonds would have been useful.

Such a problem is likely to be an issue for many Mums and Dads irrespective of whether their portfolios are professionally or self-managed. Unfortunately, the performance schedules of many advisers' quarterly reports don't split performance by category so the poor performance of one's bond portfolio may not be immediately apparent.

It is vitally important, if one is to prudently manage one's portfolio, that investors need to be able to drill down into their annual performance reports to see those areas where their adviser has either beaten or underperformed the benchmark index.

Ideally, this will mean a table setting out the performance of their portfolio, by sector, with the relevant benchmark performance detailed alongside. Retail investors paying a quarterly fee need to demand this information from their advisers and read it.

This sort of increased engagement between investors and advisers would likely, if adopted by enough retail investors, do as much to improve the investment environment as any legislation.

It would also be helpful to know if 2012 was going to be a "risk on" or "risk off" year. In the absence of a crystal ball, prudent investors, as always, should have a dollar each way.

- NZ Herald

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Personal finance and investing columnist at the NZ Herald

Brent Sheather is an Authorised Financial Adviser and personal finance and investments writer

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