Betting on shares

By BRENT SHEATHER

The NZ Superannuation Fund is up and running with $2.4 billion and the Government is putting in about $40 million more every week.

The numbers are huge, yet the rules, rationales and processes behind the fund's investment decisions are similar to those made by Mum and Dad in Pukekohe with their retirement savings.

Before deciding how the money will be invested, the fund enlisted two of the world's biggest names in the investment consulting business, Mercer Investment Consulting and Frank Russell.

Mercer duly produced an impressive 117-page document detailing the investment plan and, more importantly, the assumptions behind those decisions.

A key part of any savings plan, for $50,000 or $5 billion, is the asset allocation decision - how the money is divided among investments such as bonds, property and shares and, within these areas, whether it is invested locally or overseas.

There was a lot of discussion over that second question, with various interested parties such as the stock exchange and brokers urging the fund to put a lot of money into New Zealand shares.

In the event, the Mercer report concluded that the fund should put 80 per cent of its money into "growth" assets - mainly shares, with a little property - and 20 per cent into fixed interest. As far as the growth assets are concerned, only 10 to 12 per cent will be invested locally.

Compared with the average New Zealand pension fund, the super fund will have much more of its money in growth investments (80 versus 60 per cent) and a lot less in bonds (20 versus 40 per cent). That's also more than Australian, American and British pension funds typically have in growth assets, and the trend seems to be toward less in shares.

The fund's focus on shares partly reflects its long-term approach - 17 years will elapse before any withdrawals are made.

But what is worrying is that the fund's strategy may simply reflect an over-optimistic view of the future return on shares, compared with bonds.

The fund's website reiterates the not-so-novel idea that "over long periods of time shares have outperformed other types of investment". The Mercer report tells the fund that it can expect 8.4 per cent a year from international shares and 5.7 per cent from international bonds.

But there is a danger that the overseas sharemarket party may be ending just as the fund pours its first drinks.

When looking at the most commonly cited US data, from 1926 to last year, shares have definitely beaten bonds, returning 11 per cent a year versus 5.3 per cent.

"So what?" you might say. Nearly every investment statement warns that past performance may not be repeated and, in the case of shares, great past performance is the main reason why it will not be repeated.

Shares are more expensive than they were 70 years ago.

Dividends are a vital part of sharemarket returns but dividends are now tiny. In 1926 the shares in the S&P 500 index of US shares paid a dividend yield of 5.5 per cent. Today they pay less than a third of that.

A research article by two prominent academics and investment managers in the US Financial Analysts Journal - a publication the Mercer report quotes extensively - suggests that the popularity of shares rests largely on the fact that they have outperformed bonds by 5 percentage points a year. In the jargon, that is the "risk premium" - the extra investors get for accepting the volatile returns from shares.

But, says the article, in future the risk premium will be much smaller, and could even be negative. If that is true, shares will produce a lower return than bonds, as well as being riskier.

The paper, What Risk Premium Is Normal?, by Robert Arnott and Peter Bernstein, concludes that shares beat bonds over the past 75 years largely because of a number of non-recurring developments. These include a dividend yield that was 5.5 per cent 75 years ago (now about 2 per cent) and the fact that the P/E ratio - the price investors will pay for a share relative to the company's earnings - has risen steadily.

The authors suggest that, based on present dividends and a static P/E ratio, shares can now be expected to return no more than bonds, and that it is sensible to expect both shares and bonds to return about 2 to 4 per cent a year, after inflation.

ARNOTT and Bernstein's logic also suggests that local shares, with relatively high dividends, will beat overseas shares, but Mercer has this the other way round.

The fund's expectation of earning 8.4 per cent on foreign shares can be viewed another way.

Economics say the return on shares equals the dividend yield plus the growth rate of those dividends. The dividend part is easy to work out - for overseas shares it's no more than 2 per cent before tax.

What about the future growth rate? Mercer's most likely scenario assumes global economic growth of 5 per cent annually for 20 years. And a recent Financial Analysts Journal article points out that over the past century or so, in 16 countries, dividends have consistently grown about 2 percentage points less than economic growth.

So, if Mercer is right in its 5 per cent growth forecast, dividends should grow about 3 per cent. Add that to today's 2 per cent dividend yield and international shares are likely to return 5 or 6 per cent - well below the Mercer report's 8.4 per cent.

Fund chief executive Paul Costello says 0.5 per cent of that forecast return will come from a fall in the kiwi dollar so, before taking that into account, overseas shares must be expected to return 7.9 per cent a year.

That is higher than some forecasts from brokers - not usually cautious when predicting stockmarket returns.

The point is that if the prospective return from overseas shares is too high, the mix between New Zealand and international may be wrong and the allocation to shares generally may be high.

How will we or the Government know whether the fund is doing its job properly? We cannot realistically expect any industry experts such as brokers, investment consultants or fund managers to publicly criticise the fund - slagging off your biggest client is not a great career move.

US mutual fund (unit trust) managers must provide a simple graph of their performance compared with the relevant benchmark. A share fund might compare itself with the S&P 500 index.

Such comparisons are used worldwide, yet Mercer recommends measuring the fund's long-term performance against the growth in average weekly earnings.

This benchmark is like assessing John Mitchell's performance based on an All Black game against Romania. A fairer comparison would be against a benchmark made up of the relevant indices, weighted to reflect the fund's asset allocation, and/or a comparison with similar funds.

Compared with other long-term savings funds, both locally and overseas, the super fund's asset allocation looks aggressive. Combined with a world stockmarket that looks expensive, its strategy could be a recipe for disappointment.

* Brent Sheather is a Whakatane investment adviser.