The big fall in interest rates that has occurred in the last ten years is now having some profound effects on investors' behaviour and in particular asset allocation.
Unsurprisingly there is a sustained move amongst retail investment portfolios away from bank deposits and bonds into higher risk asset classes like property, shares and indeed anything that promises higher returns.
Whilst moving to more diversified portfolios generally makes sense the financial markets have a long history of surprising investors who become overly enamoured with a particular theme.
False gods have included tulip manias, infatuations with canals and railways and, more recently, love affairs with technology and collateralized debt obligations, all of which have ended badly. With the hunt for yield becoming so widespread the worry is that this too will be recorded as another exercise in idolatry.
To its discredit the fund management industry, with the notable exception of Vanguard, has an uncanny ability to discern investor weaknesses and exploit them.
One fund manager summed up the strategy once when he reportedly said "if the ducks quack, we feed them".
Investors thus need to keep their wits about them ensuring that the yield-god they worship is a real one and at all times reconcile the competing objectives of the return of their capital and the return on their capital.
Increasingly retail investors are moving out along the risk curve, i.e. less fixed interest and more risky assets. They need to be careful because headline yields can be manufactured and it is often difficult to discern what is real and what is not, even for experienced investors and maybe even regulators.
A few months ago this column highlighted a large and apparently popular property syndicate whose advertisements emphasized an income yield of 8 per cent. However anyone who bothered to read the fine print (probably no one) would see that the high yield was substantially a function of financial engineering in that it benefitted from high gearing at a low interest rate.
In fact the property was actually being purchased at around a 6 per cent yield and the only reason equity holders might receive 8 per cent was because the equity returns were being subsidised by short term borrowings at around 4 per cent.
The obvious risk is that interest rates rise substantially thereby reducing the yield on equity and at the same time reducing the valuation of the property.
With the hunt for yield becoming so widespread the worry is that this too will be recorded as another exercise in idolatry.
SHARE THIS QUOTE:
This area needs the attention from some informed regulatory oversight as disclosure doesn't work in complex matters, i.e. anything more complicated than single figure addition and subtraction.
Other examples of the worship of false gods abound: the NZX listed investment companies run by Fisher Funds long ago instituted a policy whereby each quarter the funds give shareholders back some of their capital.
Directors label this return of capital a dividend thereby giving investors the warm fuzzies. You can however see from the accounts of the Marlin Global Fund, for example, that most of the dividends are actually a return of capital.
For example Marlin Global pays a dividend of 6.88 cents per share which on a share price of 79 cents is a dividend yield of 8.7 per cent.
This of course looks fabulous to the naive yield crazed investor but the reality is that all of this "dividend" is actually a return of the capital of shareholders.
According to the Marlin profit and loss account for the year ended 30 June 2016 dividend and interest income of $966,000 doesn't even cover operating expenses of $1.65 million.
This latter figure is made up of a management fee of $880,000 and various other operating costs.
There is no actual earnings, in the conventional sense of the term, available to fund a dividend. One could take this capital distribution model to its ultimate conclusion by paying out all of the company's capital to shareholders thereby delivering a fabulous yield of 100 per cent.
Next year however with all the company's capital gone future dividends might be something of a problem.
The level of dividends from a managed fund can give useful information to investors as regards fees but this move completely subverts that process and we have the ridiculous situation where the yield on some Kingfish funds, with very high fees, are higher than the yield on exchange traded funds investing in the same markets with low fees.
Over the last 35 years the average capital investment required to maintain buildings in a state of constant quality was roughly 2 per cent of market value.
SHARE THIS QUOTE:
Unfortunately none of this has attracted the attention of the government departments designed to look after retail investors. One suspects the reason for the lack of action is that the Ministry of Business and Investment Banking, the FMA and the Ministry of Financial Capability don't fully appreciate the issues.
One other area where investors need to be careful is the property sector.
A recent report by Robert Arnott's Research Affiliates (RA) highlights the fact that, whereas the profits available for dividends from companies are after a deduction for depreciation, property companies reported profits don't have a depreciation charge deducted.
Looking at long term data for US commercial property RA concludes that an amount equivalent to 2 per cent of market value needs to be deducted to maintain a current quality building.
The report reads "like a garden commercial property is expensive and time consuming to maintain. The constant toil of maintaining a property, not only to the expectations of the current pool of renters but also to compete with newer and upper scale properties being built can be a significant cost.
Over the last 35 years the average capital investment required to maintain buildings in a state of constant quality was roughly 2 per cent of market value."
This is significant, particularly as regards property syndicates, which typically pay out all of their earnings with little or no deduction to maintain constant quality.
In contrast the listed property trusts usually retain 10-20 per cent of earnings to maintain the real value of the property. Given that fact investors need to look carefully at yields on property and remember that in some cases a 2 per cent deduction from headline yields need to be made to compare apples with apples.
It's a pity that the experts at the Commission for Financial Capability whose objectives include ensuring that "New Zealanders are better educated and motivated to make informed financial decisions" and that "New Zealanders have more trust in the financial services sector" haven't been able to get more engaged in these sorts of issues.
Their input on investment matters seems to be limited to generic advice about the need to save which is nice and most importantly doesn't offend anyone, but I guess they have to play to their strengths. The downside is that it is not so helpful to retail investors actually making investment decisions.