Happy returns from buried OE booty

By MARY HOLM

Q. I accumulated a sum of money while on my OE that I left in England knowing that a stash would be useful as I would never again have the chance to work legally in Europe.

I put the lump sum in Cheltenham & Gloucester's London Account and have pretty much ignored it for 10 years. It just rolls over every year with interest compounded.

But on receiving my investment statement recently, I see that although I now have accumulated £8700, the interest rate is a dismal 0.95 per cent, somewhat less than the rate it started on.

Obviously I can do better with this money.

I have a mortgage on an Auckland house with my partner, which we split down the middle, with about three years and $70,000 to go. We are childless and will remain so, and apart from the mortgage, we have no debt.

I know that in general it is best to pay off debt first, but I want that money to stay in Europe for future travel, given the horrendous cost of travelling on the Kiwi rouble.

I would love to hear your advice on how I can best invest that money.

A. Whichever move you make, you're taking a bit of a gamble. We need to find which is the better bet.

There are two factors here: interest rates and foreign exchange. We'll look at interest first.

If you leave the money in England, you are earning about 0.6 per cent after tax (assuming you are in the 33 or 39 per cent tax bracket.) What would you earn if you bring it back here?

Let's say your mortgage interest rate is 7 per cent. If you use the money to repay part of your mortgage, you are avoiding paying 7 per cent on that money.

That increases your wealth in exactly the same way as investing the money at 7 per cent after tax. It dwarfs the England return.

But what about foreign exchange?

If you bring the money here and then spend it later on travel in Britain, you run the risk that the dollar will depreciate against the pound in the meantime.

And, according to finance textbooks, market players generally expect a high-interest country's currency to fall relative to a low-interest country's currency. What you gain on the interest, you lose on the foreign exchange.

This helps to explain why people aren't forever moving their fixed-interest investments around the world.

But the current New Zealand situation is a bit of an anomaly. Our interest rates have been higher than most other Western countries for some time, and yet our dollar has been rising against their currencies.

Research suggests there may be special factors at play in New Zealand. It's pretty complex stuff, to do with default risk, liquidity and currency risk.

In short, some academics think New Zealanders may continue to pay higher interest than many other nationalities, without our currency falling to cancel that out.

Still, there's no guarantee that the dollar won't fall. How bad would it be if it does?

Experts say it's fairly unusual for a currency to rise or fall more than about 8 per cent a year. Over longer periods, of course, the volatility is greater. In two years, the typical range is plus or minus 11 per cent; in five years, about 18 per cent.

Meanwhile, if you put the money against your mortgage, that's the equivalent of earning about 6.4 per cent more a year, after tax, than in England.

In two years, you'll have about 13 per cent more. In five years, about 36 per cent more, because of compounding.

The dollar would have to take an unusual dive for you to be worse off over two years. Over five years, it would have to be a pretty remarkable plunge.

And those are bad-luck scenarios - the dollar might just as easily rise against the pound. As BNZ economist Tony Alexander said recently: "The simple truth is that you cannot forecast exchange rates".

And if the dollar does rise, you'll make out like a bandit. Over five years you'll have 36 per cent more money plus your foreign exchange gain. It will be Grand Tour time.

All of this assumes, of course, that interest rates in both countries won't change. They almost certainly will.

But you can be pretty confident that British savings rates will stay below New Zealand mortgage rates for the next few years.

Bringing the money back here may be a gamble, but the dice are loaded in your favour.

There's just one problem with all this: you seem to like the idea that the money is sitting there waiting for your next trip, rather than being swallowed up in your mortgage.

But there are ways to cope with that. If you have a revolving-credit mortgage, when you plan to travel you can just increase the mortgage by the amount you bring back from England plus interest.

If not, tell your mortgage lender that you want to make the extra mortgage payment on the understanding that you can borrow it back later. Lenders will often do that.

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Q. I am sure many readers would have had a chuckle when they read in your column last week that a unit trust research house rates two of your favourite index funds with its lowest rating, one star.

Such a rating is not surprising to many in the industry, as ultra-low fees and tax effectiveness don't seem to count for much with these "gurus", who seem more preoccupied with less tangible factors such as "investment process" and whether the fund manager has a toll-free number.

It's worth remembering that index funds - favoured by the likes of Warren Buffett, John Bogle and the leading British financial services regulator (the Financial Services Authority) - pose a major threat to the livelihood of active fund managers and their cheerleaders, the unit trust research houses.

For example, not much point in paying for someone to "research" the best active managers when an index fund will inevitably outperform in the long term.

Regulators globally are fond of warning us that "past performance is no guide to the future". But they might like to add that "the present ratings of fund research groups are no guide to the future either".

A. Ooooh! You're not one for the soft touch.

I appreciate the support for the index funds - which invest in all the shares in a market index. And you make some good points. But you might have overstated it just a bit.

The FundSource ratings under which the two funds - AMP's Passive International Shares Trust and Tower Tortis International - received one star did take fees and taxes into account.

In fact, they are based simply on three-year performance, after fees and taxes, and volatility.

Furthermore, under FundSource's other ratings - the qualitative ones that are based on "portfolio, process and people" - Tortis International and the Passive fund's first cousin, WiNZ, are recommended.

Also, you're stretching it to say index funds will inevitably outperform active funds over the long term.

In all the research I've seen, a few active funds have beaten index funds over long periods. But most haven't, especially after taxes and fees.

Because it's impossible to know which active funds will turn out to be the stars, it's a better bet to go with the index funds.

Settling for being, say, third out of 10 beats trying to be first or second when there's just as big a chance you will be ninth or tenth.

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Q. Re passive or active funds, we (you and your readers) debated this two or three years ago.

One view expressed then was that passive (or index) funds are better during a bull market and active funds are better during a bear market.

Being an inquisitive chap, I decided to test this by joining Tortis International and Tower's Global Fund on exactly the same fortnightly basis.

Two months ago I finally declared a winner and transferred all to Tortis.

Quite simply, despite the bear market, the tax implications of losses, and the currency movements (all of which should favour the active fund), the passive fund still won. Not by a great deal but enough to end the experiment.

A. Interesting. You've got to admit, though, that we shouldn't draw sweeping conclusions from looking at just two funds over one bear market.

Still, a recent report from Standard & Poor's backs up what you say, and it looked at many American share funds. Its findings:

* Over the past three years, the S&P 500 index, which covers big US companies, performed better than 56 per cent of active funds that invest in big companies.

* More dramatically, the S&P MidCap index, which covers mid-sized companies, performed better than 73 per cent of active funds that invest in companies of that size.

* And the S&P SmallCap 600 performed better than 70 per cent of active funds investing in smaller companies.

We need to acknowledge that index funds don't perform quite as well, after fees, as the indexes they are based on, because they must cover their running costs.

Also, US index funds don't have their New Zealand counterparts' tax advantage in rising markets and disadvantage in falling markets. So you wouldn't expect such a big difference in bull v bear market performance.

And, as I've said many times, three years is too short a period to judge any share fund. I would like to see research over many bear markets.

Still, the numbers are thought-provoking.

By the way, S&P also produced five-year numbers, which cover a part-bull, part-bear period.

The findings for big-company funds (the index beat 57 per cent of them) and small-company funds (the index beat 66 per cent of them) are similar to the three-year findings. But at mid-company level, the index beat a whopping 93 per cent of the funds.

To another reader who asks, "Do you think it would be a smart move to pull out of all the active funds and stick the lot into passive funds?", my response is, "Probably".

* Mary Holm is a freelance journalist and author of Investing Made Simple.

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