Most financial advisers will be keen to tell you that diversification is critical in any portfolio.
They'd be right.
In the "perfect portfolio", personal circumstances and an investor's risk appetite are always a great place to start. Then, there are plenty of different investment types to think about before you even get to focus on the detail of equity investments. Equities, property, bonds, bank term deposits and even good old cash.
The mix of all of those things reflects the overall risk profile that an investor is prepared to take and the timeframe they are working to. If an investor is looking to access cash in 20 years, chances are that a portfolio comprising bank term deposits probably won't cut it.
A diversified portfolio sets an investor up to withstand, and potentially benefit from, future adverse events. But have the rules of diversification changed in our current, Covid-impacted world?
Geographic diversification can protect an investor from short-term "shocks" to specific markets or currencies. For example, the New Zealand dollar has fallen in value over the last month against its counterparts in Europe, Australia and the UK (although it has been relatively stable against the US).
The main reason is likely related to the impact of the quantitative easing measures enacted by the Reserve Bank, which have seen the RBNZ purchase around $100 billion of bonds on the debt market — effectively increasing the amount of NZ dollars in circulation as the RBNZ creates cash to fund the purchases.
That means that Kiwis who invest in companies in Europe, Australia and the UK are seeing the value of those investments increase (in New Zealand dollar terms) — even if there is no underlying change in the fortunes of their investments.
Somewhat ironically, New Zealand is probably seen as an investment "safe haven" at the moment, with companies focused on our domestic economy (eg, gentailers, retailers, telcos) holding their own so far. Nonetheless, while that may affect portfolio choices in the short term, New Zealand's current haven status doesn't mean it will stay that way.
Geographic diversification does not always help in the event of a global issue or event but that's where sector-based diversification can help.
Even as the Covid-19 pandemic continues to unfold around the world, healthcare and technology sector shares have continued to increase in value.
If an investor had invested in the eight health-related shares on the NZX at the beginning of the year (whether equally or weighted by market capitalisation), their returns would be around 50 per cent this year, compared with a more or less flat return from the NZX50 index. In the US, the tech-heavy Nasdaq index is trading at close to its all-time highs.
The trend is mirrored locally, with the likes of ERoad, Plexure Group and Pushpay Holdings all producing strong share price gains so far in 2020.
The flipside is also true — an investment in travel and tourism shares in early 2020 would not have worked out that well for an investor.
A portfolio based on sector diversification at the beginning of the year may have allowed an investor to benefit from subsequent, Covid-related events. Maybe even enough to offset their losses in the travel and tourism sector.
Diversification on the local exchange
It can be daunting for retail investors to create the "perfect portfolio". There was a time when it was remarkably difficult to do — simply due to the scale of investment required, the transaction costs involved and the sheer number of companies that investors had to research and invest in.
Then along came exchange-traded funds — ETFs for short. These funds invest in a "basket" of assets (ie, shares, property, bonds or even cash) that reflect a specific class of investment. They are then traded on a stock exchange, just like other shares. The first ETFs emerged in the 1990s and proved instantly popular with investors.
An ETF will attempt to mirror a specific index: for example, the NZG fund (listed on the NZX) tracks the NZX50 index. The fund buys and sells shares based on the underlying weightings of companies in the NZX50 to maintain a close track with the index. It means that investors don't need to know a whole lot about individual companies; they just need to be aware of the amount of their total investment portfolio they wish to hold in New Zealand.
The argument between this "passive" style of investing and a more "active" approach has gone on for years. Research supports the argument that a passive investment (like an ETF) performs just as well in the long term as an "actively managed" fund — once management fees are included.
The reality is likely to depend on an investor's portfolio strategy. A mix of direct investment in assets that are well-understood by an investor is likely to be balanced by an investment in ETFs to support wider diversification.
New Zealand was a relatively early adopter of ETFs, with the first ETF appearing on the NZX in 1996. This has since evolved into NZX-owned Smartshares, which today offers 35 ETFs covering different asset classes and geographies. The underlying fund is often managed by a large fund provider (eg, Vanguard or Blackrock).
Smartshares has seen significant growth in its ETFs — up from $500 million in 2014 to over $3.6b today. That's still a small proportion of the $200b in funds under management in New Zealand. On the NYSE and Nasdaq exchanges, around 30 per cent of sharemarket trade value is in ETFs. Hugh Stevens, Smartshares' chief executive, points out that the similar figure in New Zealand is only around 5 per cent, although that is a 10-fold increase in two years.
Stevens' focus is clearly on growth. "We see plenty of upside in how investors can use ETFs to build a foundation for their portfolio".
There are only two Smartshare funds that allow sector-specific investment: the Healthcare Innovation fund and the Automation & Robotics fund, both launched by Smartshares in 2019. Both have performed well since listing.
Create your own perfection
Smartshares is by no means the only option; Wellington-based InvestNow offers a total of 144 funds, including active funds managed by local investment managers. While these cannot be traded like shares on the NZX, it's a simple process to register and invest.
There's a greater range of exchange-traded funds available on the ASX, easily accessed by Kiwi investors. It's important for investors to recognise any tax implications in this scenario, however — an investor may be subjecting themselves to the Foreign Investment Fund (FIF) tax regime when there is a similar fund available on the NZX that offers a much simpler tax structure.
Investing directly in companies takes more work for an individual investor. Research into the strengths and weaknesses of a company is critical. Direct investment in a company can also create a form of geographic or sector diversity depending on the nature of their business.
For example, both Fisher & Paykel Healthcare and a2 Milk have high levels of non-NZ dollar revenue, with Fisher & Paykel in particular exposed to a true melting pot of underlying geographies. No surprise that their share prices have been increasing in recent days as the NZ dollar falls in value against most major currencies.
Their rising share prices are also supported by the creditable performance put in by both companies. They're not just operating in strong sectors, they can be regarded as best-in-class within those sectors. A2 Milk continued its growth pattern, announcing a 34 per cent increase in net profit this week, while F&P increased its revenue and profit forecasts for the year ahead.
Whether through direct company investment or ETFs, there are plenty of local options for creating a balanced investment portfolio that provides asset type, sector and geographic diversification.
So has Covid-19 impacted the manner in which investors diversify? Probably not. It may have sharpened up investor focus around risk and determining the likelihood of future scenarios, which is probably no bad thing in the long run.
In terms of accessing investment types that support diversification, there are plenty of options; "Don't leave home until you've seen the country" is just as relevant for Kiwi investors as it is for our battered local tourism sector.
- Oliver Mander is not an authorised financial adviser (AFA), and nothing in this column should be construed as financial advice. Seek out the advice of an AFA to support your investment decision-making.