Money Matters: Index numbers don't always add up

By MARY HOLM

Q: I write to seek your views on overseas index funds.

From time to time you advise readers to invest in these funds and usually speak of WiNZ (which follows a world share market index).

I'm familiar with the track records of the Dow Jones and S&P500 but I don't know how these US indexes compare with those of Europe and the world.

Could you give me the comparisons over, say, 5, 10 and 25 years?

A: I can do even better.

The Dow Jones Industrial Index and the S&P500 are capital indexes, which means they reflect changes in share prices but do not include dividends.

I've managed, though, to get data on the gross versions of both indexes, which do include dividends. And I've compared them with other gross indexes.

Looking at share returns without taking dividends into account is like looking at property returns without taking rent into account. It's silly.

It makes performances look worse than they really are. And - because companies in some countries tend to pay higher dividends than in others - it makes comparisons meaningless.

The trouble is, the most quoted indexes tend to be capital ones. That's because they've been around longer.

People are used to hearing about the Dow Jones and the NZSE40 capital index. So the media give them what they are used to, even if it is pretty misleading.

I would love to see the media get together and all switch to gross indexes. We'll start with Money Matters today!

The numbers I've got are the Dow Jones gross (biggest US companies); the S&P 500 gross (top 500 US companies); MSCI UK gross; MSCI Europe except UK gross; and MSCI World gross. The MSCI indexes all cover big companies in the world or region.

All of the numbers are reported in New Zealand dollars.

Before you go any further, which index do you think showed the best performance over the past 25 years?

You'll find out in a minute. Now, the numbers. Average annual returns for periods ending March 31 this year are:

* Over the past five years: World 21 per cent, UK 22 per cent, Europe 24 per cent, Dow 27 per cent and S&P 27 per cent.

You're probably not surprised to see the US at the top.

* Over the past 10 years: UK 14 per cent, World 14 per cent, Europe 17 per cent, S&P 19 per cent and Dow 20 per cent.

Again, the US triumphs.

* Over the past 25 years: World 17 per cent, Europe 18 per cent, Dow 18 per cent, S&P 18 per cent and UK 19 per cent.

Did you get the UK? I'm guessing most people wouldn't have.

I've got two worries about these numbers.

One is that they are much higher than many experts expect future returns on shares to be.

That's partly because inflation is now lower, and partly because, as Baby Boomers retire and switch from shares to fixed interest, that trend is expected to hold back share prices.

So don't go expecting average annual returns of 20-plus per cent, or even 10-plus per cent in the decades to come.

My other worry is that world returns don't fare well in the comparisons. This could lead you to favour the US or UK over a world index, and I think that would be a mistake.

The US and UK may have done their dash. Some other country may rise to the fore. Nobody knows.

I do know, though, that if you invest in a world index fund you won't miss out on whichever economies are the stars of the coming decades.

Note, too, that we're not talking big differences in the performances of the different indexes anyway.

In all the periods - and over 25 years in particular - the range of performances is remarkably small.

Which just goes to show that you shouldn't get too upset when your share fund investment does badly over a year.

Over longer periods, the average returns are much steadier.

Q: My husband and I are in our late 30s with one child and are expecting our second child.

My husband has an above-average wage and (touch wood) reasonable job security.

We are likely to have only the one income for the next 18 months to two years, though I could return to work sooner if necessary.

We own our own home (complete with mortgage) but have no other savings for retirement, children's education etc.

We are considering "trading down" to a smaller property so our mortgage will be repaid sooner.

Are we best to channel all our surplus funds into mortgage reduction or have lower mortgage repayments while starting a monthly savings plan?

I am worried that if we don't commit to a savings plan of some description (however small), we will find ourselves without any savings for our retirement. I am already resigned to camping holidays well into my fifties!

What are your thoughts?


A: First, that camping holidays are wonderful. At least they're wonderful at making you appreciate the comforts of home when you get back.

And that will be true even if you return home to a more modest abode.

I really like your idea of moving to a smaller property. Too many New Zealanders have gone too deeply into debt to buy a flasher house than they need.

They might live in relative luxury. But over the years they pay hundreds of thousands of dollars in mortgage interest. And these days there might not be much of a capital gain to show for it. They retire much worse off than they would otherwise be.

Your question about whether you should repay your mortgage fast or start a savings plan comes up quite often. That's probably because there's no clear answer to it.

Anyone who can make a buck out of your savings will, of course, tell you that's the way to go.

But other more objective advisers say you can't do better than repaying your mortgage. How come?

We measure someone's wealth, or "net worth", by taking their total assets and subtracting all their debts.

You'll affect your net worth equally by adding $100 to your assets, in the form of savings, or paying $100 off your mortgage.

But - and here's the objective adviser's point - if you pay $100 off your mortgage, you avoid paying around 7.5 per cent in interest on that $100.

If, instead, you had put the $100 in a bank, you'd earn only around 6 per cent on it. After tax, it would be lower still.

You'd be paying out more interest on that last $100 of mortgage than you'd be earning in your savings account. That's mad.

And that's always going to be the case, whatever happens to interest rates. Banks will always charge more for their mortgages than they pay on savings. Otherwise they would go broke.

You could, of course, put the $100 into, say, a share fund. It's quite possible that your after-tax return would then be more than the mortgage interest rate.

The trouble is that it's a riskier investment. Returns will be all over the place, including below zero in some years.

By comparison, repaying your mortgage is like a virtually risk-free investment. You always know exactly where you stand with it.

Because of that risk difference, objective advisers prefer mortgage repayment.

Pay off the loan as fast as possible, they say. Once the loan is repaid, put the same amount each month into your savings.

I'm not fully convinced, though, that that is the right advice for everyone.

As far as numbers go, it's correct. So I would always recommend putting most of your available money into mortgage repayments.

But, once you take into account a few psychological factors, there's something to be said for squirrelling away, say, $100 or $200 a month.

For one thing, apparently quite a few people who have concentrated solely on reducing their mortgage don't have the willpower to start serious saving when their mortgage is repaid.

Instead, they splash out on travel, cars, boats, furniture or whatever.

Reality doesn't hit until close to retirement. By then it's too late to accumulate much.

If, instead, they had been saving a little for many years, they'd have the savings habit.

Encouraged by watching that money grow, they might be more inclined to seriously add to it when they've paid off their mortgage.

Another thing: As we've already established, there's no point in saving in a bank if you've also got a mortgage.

To make sense of it all, you should go into a share fund or similar.

That means volatility, which many people say they can't cope with. But if you want higher average returns over the long run, you need to get used to volatility.

And what better way than by putting just $100 a month or so into a fund? If the value of the investment falls for a while, you haven't got much at stake.

Over the years - as long as you stay in the share fund regardless of market movements - you'll learn about long-term trends, which are likely to be good.

By the time you've paid off your mortgage and are ready to save more seriously, you will be more confident about share investments.

There's another advantage, too, in having at least some of your assets in the share market. That's diversification.

Those who concentrate only on mortgage repayment have all their assets in the one market, housing. And, as we've seen recently, that's not always a high-growth sector.

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

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