KEY POINTS:
Venture capital, a concentrated equity portfolio, big bets on small companies, an investment strategy so secret not even its own shareholders are allowed to know exact details of the portfolio. You might think that this is the latest hedge fund from a tax haven like Monaco or the
Bahamas, consistently producing double-digit returns with low volatility and run by an investment superstar with a double-barrelled name like Jolyon Harrison-Smith.
Well, that certainly appears to be the investment strategy. But unfortunately the similarities end there. The fund is actually the Eastern Bay Energy Trust (EBET), based in my home town, Whakatane.
There are no double-barrelled names, volatility is high and the investment returns are certainly into double-digits. But unfortunately the numbers are preceded by a negative sign.
Someone looking at the investment strategy of the EBET might well think they were looking at Whakatane's first hedge fund because the strategies that have been adopted of late are more like what you would expect from someone interested in getting rich quickly rather than adopting the more measured approach typical of its peers. Indeed, they look aggressive even compared to a growth-oriented entity like the NZ Super Fund.
First some background. EBET represents the 23,800 electricity consumers in the Eastern Bay of Plenty, and the energy-related purposes in its trust deed require the trust to proactively support a reliable and affordable supply of electricity, in particular to consumers in rural and remote areas of the trust's district. It has about $70 million in assets with which to achieve its objectives.
So how might an entity like EBET invest its money? What most institutions charged with fulfilling a specific objective - like, for example, paying a pension to a workforce for the remainder of each employees' life - do is, as far as possible, match their liabilities with appropriate assets.
So what are the nature of EBET's liabilities? The trust deed requires EBET to "proactively support a reliable and affordable supply of electricity in particular to consumers in rural and remote areas". In practice this means paying for insulating houses and buildings, heat pumps, lighting upgrades for schools, community organisations, marae and sports clubs.
The Eastern Bay has lots of sunny but cold days in winter, thus there is considerable scope for EBET to help keep the locals warm. As you can imagine this requires lots of cash, so it seems pretty clear that EBET should be managed with at least a balanced mandate focusing on income and growth rather than just an emphasis on increasing the capital. Being warm now is preferable to being warm next year.
In the year ended March 2008, EBET gave away $2 million of some $3 million of income. So far so good, until you realise that EBET started the year, in March 2007, with some $83.7 million in assets. The $3 million in income is a cash return of just 3.6 per cent on the $83.7 million, not a great effort when you consider that yields of 8 per cent plus were then available in bank deposits and the bond market generally, not to mention 6 to 7 per cent from the local stockmarket, and 8 per cent and greater from the listed property market.
It is reasonably straightforward today to put balanced portfolios together for retired mums and dads achieving cash yields, pre-tax of 8 per cent with the expectation based on historic returns that some two-thirds of the portfolio and income will be protected from inflation.
If that $83.7 million was earning 8 per cent there would be some $6.7 million which could be distributed to warm EBET's beneficiaries, more than three times what EBET managed to distribute in 2008.
So where has EBET got its assets? The key variable in any portfolio is the asset allocation - how the money is allocated between income assets like bonds and growth assets like property and shares. The average pension fund, which must strike a balance between producing income to fund retired individuals and achieving capital growth for younger employees, has for the past 30 years or so allocated its funds about 40 per cent in bonds and 60 per cent in property/shares. Recently there has been a lot of argument in the UK and the US that mature pension funds which want lots of income and low volatility should be 100 per cent in bonds.
So back to Whakatane's hedge fund. Exactly where is EBET's money? EBET doesn't disclose this data by way of a simple pie chart, unlike its peers, but from its accounts EBET seems to have adopted a very aggressive asset allocation with 97 per cent in shares, 1.4 per cent in property and about the same weighting in bonds. That looks like a higher-risk strategy - the NZ Super Fund has a longer investment horizon, and no need for income, yet it has 19 per cent in bonds, about 12 times EBET's weighting.
A closer look at EBET's accounts gives further insights into its strategy - risk is compounded by EBET's concentrated portfolio. Of the 97 per cent of its assets in shares, 87 per cent is in the small Eastern Bay of Plenty energy lines company Horizon Energy. This compares with share weightings of its peers as follows: BOP Community Trust, 44 per cent; Rotorua Energy Trust (REC), 56 per cent; and Tauranga Energy Trust (TEC), 96 per cent.
Furthermore BOP and REC have properly diversified share portfolios as per accepted institutional best practice. TEC has most of its equity exposure in Trustpower but Trustpower is a much bigger, more diverse company than Horizon Energy and the shares are more liquid. But where EBET really differs from its peers is that its diversification away from energy shares has been via a mix of high-risk, small companies and unlisted ventures with limited liquidity, little diversity and, as we shall see, disappointing returns.
In contrast the BOP and REC trustees have opted for conventionally diversified portfolios with both bonds and shares. TEC has continued with its historic holding in Trustpower but its non-energy equity investment is, as per commonsense and best practice, via a global share fund with upwards of 500 companies in the portfolio and it also has a modest bond weighting.
EBET appears to have ignored the number one investment rule about diversifying. Harvard University research says that to get the maximum benefit of diversification you need to own 50 stocks in each market. Instead EBET spent some $3 million on a shareholding in a small unlisted company producing pellet fires called Parkwood Investments.
Parkwood was placed in receivership in July at an estimated loss to the trust of about $3 million. EBET also owns 1 million shares in Comvita, a well-managed but very small company listed on the NZX which is showing losses of about 50 per cent on cost; and a couple of small, illiquid and unlisted horticultural ventures somewhere near Opotiki.
Additionally, while Comvita has exciting growth prospects, it doesn't pay a dividend, which makes it a strange choice for a trust requiring lots of cash income. This non-energy portfolio appears to have performed very poorly for EBET. Commonsense would suggest that the best complement to the big weighting in Horizon Energy shares would be a high-quality bond portfolio.
Now to performance. Unfortunately taking risks hasn't paid off so far for EBET's beneficiaries. EBET's accounts show that it didn't have a good year in the past 12 months with the balance sheet shrinking from $83.7 million in March 2007 to $70.1 million in March 2008, a reduction of $13.7 million or 16.3 per cent, despite retaining about $1 million of profits.
In the same period a balanced portfolio as held by a pension fund would have recorded an estimated return of - 7.2 per cent a year.
Apparently EBET wasn't able to make its accounts available to shareholders until the day before the AGM. The 2009 year is not shaping up as a good one for EBET's beneficiaries either as this year is likely to see a sharp writedown of the non-energy portfolio. If we write off EBET's holding of Parkwood debt and equity and mark the Comvita shares to market, this implies a reduction in the trust's non-energy assets of about $4 million, an estimated loss versus cost of 50 per cent.
EBET's largest investment, 19.6 million shares in Horizon Energy, appears to have weathered the recent weakness in sharemarkets well but even this result is subject to some risk as the stock is very thinly traded. With sharemarkets around the world plummeting, EBET's trustees will no doubt be hoping for a warm winter in the Eastern Bay.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge. Private Asset Management has previously managed funds for EBET.
