Brent Sheather: The grass is not always greener overseas

Photo / NZ Herald

The performance statistics for the world stock market in the 10 years ended June 30 don't make for good reading.

The average return of the world stock market is -4.3 per cent a year in New Zealand dollar terms, with all the major markets showing losses.

However, if you look at the performance of specific New Zealand shares in the same period, things look much, much better: Auckland Airport has returned 15.7 per cent a year, Contact Energy 14.7 per cent a year, Port of Tauranga 7.4 per cent a year and SkyCity 15.5 per cent a year. The New Zealand stock market average has returned 5.8 per cent a year, outperforming the world stockmarket by 10.1 per cent a year.

Confronted with these statistics an investor must wonder why on earth his or her adviser ventured outside these shores when contemplating equity investment.

It is a good question and one which many New Zealanders should be asking themselves because, according to Aon Consultants, as at March 31 this year, the average New Zealand pension fund had shipped about 70 per cent of its equity portfolio to ostensibly greener pastures outside New Zealand and Australia.

Some of this offshore bias is because of the dismal performance of New Zealand stocks and the scandalous behaviour of New Zealand executives in the 1987-92 period, partly it's due to the clever marketing of the local financial planning industry, and offshore exposure makes sense to New Zealanders because of the small size and narrow focus of the local bourse.

Even today financial planners typically allocate 60-70 per cent of a retired investor's equity portfolio to offshore markets. Fund managers, financial planners and consultants have constructed highly profitable businesses selling the "invest offshore for growth" story on the basis that, in theory, such a portfolio will achieve higher returns and, at the same time, be of lower risk.

Investing overseas also offers intermediaries interesting opportunities to make things complex and thus charge higher annual fees, not to mention providing custodial services and executing currency transactions, which can greatly improve margins over standard domestic purchases.

Presenting to retail clients, investment experts would note the obvious things - such as New Zealand only being 0.2 per cent of the world stock market, most of our executives being either crooks, nitwits or both, and the growth sectors of technology and aerospace being virtually unrepresented locally - and advise their clients to opt for lots of international fund managers.

The theory behind such a concentration of funds overseas was that, based on historic investment returns and risk from the 90s, the most efficient portfolio in terms of maximising returns and minimising risk was around 20 per cent in New Zealand shares and 80 per cent in global equities.

The higher return/lower risk argument in favour of offshore was often expressed graphically as per the above graph.

The graph is from a US-based global fund manager with many billions of dollars under management and a busy New Zealand office.

An article in the NZ Financial Analysts Journal in 1994 went further still showing that all one's problems would be solved if one had only 10 per cent of one's share portfolio in New Zealand shares.

The problem with this analysis is that it is historic - things have changed for the better locally and for the worse overseas. When our currency was in perpetual decline, our home market dominated by risky forestry stocks, investment companies and property shares paying high cash dividends but earning no cash, overseas equities looked attractive. Not today:

1. The riskiness of NZ shares has roughly halved over the past 20 years such that the historic volatility of the NZSE Gross Index in 2010 is less than that of the World Stockmarket index.

2. The 10-year rolling performance of New Zealand shares has improved substantially, from around 4 per cent a year as at December 31, 1995, to 5.8 per cent a year for the 10 years ended July 31, 2010, and at the same time the 10-year historic return of international shares has fallen out of bed from 11 per cent a year to -4.3 per cent a year in the same period.

3. Overseas markets appear to have as many crooks and nitwits as we do, and maybe the US and Europe have more. Certainly most overseas governments have much higher levels of debt than we do locally.

So if we update the data to June 30, 2010, the graph looks quite different.

Lo and behold it tells us that based on historic returns and historic volatility, the most efficient portfolio nowadays is around 20 per cent international shares and 80 per cent New Zealand, an almost complete reversal of the 1995 position.

Admittedly the data is historic and strategies in the future should be based on expected returns and expected risk. Nevertheless this reversed situation is no doubt causing discussion in pension fund circles.

Some of this result is because of the poor performance of the world stockmarket in the past 10 years, so we should perhaps expand our time horizon to 20 years, which will give us a better approximation of the performance of international shares in the future.

The 20-year data is reproduced in the second graph. It's conclusion is not markedly different, with the most efficient portfolio being 30 per cent international shares and 70 per cent New Zealand.

So what are the experts doing now? Aon Consultants' monthly overview of pension funds showed the average offshore equity position as at March 31 was 69 per cent.

The Guardians of the NZ Superannuation Fund have no doubts as to the right course of action. Back in 2003 they ignored the not-so-impartial advice of the NZ Stock Exchange and opted for a truly heroic 90 per cent offshore weighting in their equity portfolio.

The Guardians took advice from Mercer Investment Consulting, who wrote in their "Report on Strategic Asset Allocation" that "hedged overseas shares are expected to provide a ... premium of returns and do so at lower risk" than New Zealand equities.

As at May 31, 2010 the NZ Super Fund had some 83 per cent of its funds in growth assets of one sort or another - of that only 6.6 per cent was in New Zealand shares.

So what should Mum and Dad do? Usually a good policy is to copy the experts. But retired investors need income. Dividend income from international shares averages only about 2.5 per cent a year before fees and tax, so one needs almost to be on the "rich list" to be able to afford a meaningful exposure to that asset class.

What is more, thanks to Michael Cullen's international share taxation scheme, despite the fact most people investing overseas will receive no income at all after fees, they will be taxed as if they earned 5 per cent. So at a 30 per cent tax rate the net cash income after fees will be -1.5 per cent a year.

The common practice locally among financial advisers is to covertly acknowledge fees will consume all the dividend income but conveniently assume international shares will produce a steady stream of capital gains which can be systematically realised and the proceeds spent.

As we now know the reality of the past 10 years has been quite different. If security of income is a priority and if historic risk-return graphs have any value then international shares look a good deal riskier than what is on offer locally and across the Ditch.

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