Investors tempting fate

By BRENT SHEATHER*

Various commentators, both locally and overseas, have for some time been suggesting that investors need to lower their expectations of future returns.

Economists tell us that the long-run return from the world sharemarket should be about 8 per cent a year. They work that out by adding the dividend yield (1.3 per cent) and the rate of profit growth (7 per cent a year in the United States, for the last 40 years).

Bond yields average about 6 per cent, so a portfolio which is 40 per cent bonds and 60 per cent shares could be expected to return 7.2 per cent a year in the long run, before tax and fees.

Increasingly, pundits are suggesting that it is not only investors who should be lowering their sights but fund managers and financial advisers further up the food chain as well.

At present the management and monitoring fees payable by the average New Zealander with a balanced portfolio of managed funds and a monitoring agreement with a financial planner total around 3 per cent a year, which makes a big hole in a 7 per cent pre-tax return.

While the size of those fees is obviously a big issue, it may be only part of the problem; the real concern for many investors whose portfolios are "managed" on a customised basis by financial advisers may be that their portfolios contain more risky assets than prudent management would imply, in an attempt to produce a reasonable return after fees.

But first, some background. High annual fees may partly result from the fact that much of the growth in the investment industry has occurred at a time when nominal returns from shares and bonds have been much higher than the longer term average. A sustained period of high returns, like the one which has existed for most of the years since Ronald Reagan's successful war on inflation, can create an environment of unrealistic expectations both for investors and for fund managers and advisers.

Inevitably, though, real returns are limited by economic growth and tend to return to their long-term averages, at which time fees will probably become more of a focus for investors.

Like now.

If fees are indeed too high and returns are heading lower, then a logical response by financial advisers and fund managers would be to increase investments in higher-return asset classes, such as shares, and put less into lower-return areas like bonds, and to move into high-risk instruments within each asset class.

In this way, higher returns may make up for the annual fees. The tradeoff, of course, is higher volatility. But returns are more easily understood and quantified than volatility, especially when markets are going up.

The problem for an investor is that various expenses can take a big bite out of your returns. For example, if you invest in a balanced unit trust - one that puts your money into a mix of investments - and it does indeed produce 7.2 per cent a year, before taxes, you will only get 4.1 per cent or so. The rest of the return will be eaten up by the fund's expenses (about 1.6 per cent), transaction costs (0.5 per cent) and your adviser, assuming you opt for continuing advice (1 per cent). And the remaining 4.1 per cent is still before taxes, which will further reduce the return you get.

Rightly or wrongly, many private investors tend to compare their returns with current short-term bank interest rates. Investors tend to question the performance of their advisers if they believe their funds would be "better off in the bank".

A balanced portfolio, like the one used by the average pension fund (40 per cent bonds, 10 per cent property, 50 per cent shares) may, in the long run, struggle to beat the 5.5 per cent now available on short-term bank deposits, after paying the annual management and monitoring fees typical in the New Zealand fund management industry.

Given the difficulty of "beating the bank" the logical reaction of advisers and fund managers is to opt for higher risk instruments within each asset class - BBB rated bonds instead of AA, for example - and/or to increase the proportion of funds in risky assets such as property and shares. A portfolio which is entirely in shares implies an 8 per cent return before tax and fees, and the exposure to shares can be increased further yet, using options and borrowing.

The predilection for higher risk assets is further reinforced by the tendency for higher risk products to pay higher levels of commission. Skellerup bonds were very popular with some advisers a few years ago partly because they paid a commission of 1.5 per cent - a level more typically paid by share issuers rather than debt issuers.

Property syndicates provide another example of higher risk and high commissions, as do hedge funds and the various leveraged share schemes so popular in Australia and the US a year or so ago.

The area of fixed interest managed funds provides a stark illustration of the risk/return/fee tradeoff; what does a fund manager do, faced on the one hand with an efficient market which is extremely difficult to beat, and on the other hand with fees which are immediately going to eat up 20 per cent or so of the returns? Of course, he or she piles into higher risk corporate bonds and hopes for the best.

Six months ago, one of New Zealand's largest fund managers announced that its international bond fund would increase its allocation of funds to riskier corporate bonds from below 25 per cent to around 50 per cent. One analysis of the move simply printed verbatim the assertion by the fund's manager that the changes would lift the targeted rate of return from 6 per cent a year to 7.5 per cent. No mention of the fact that, even if the whole fund was invested in investment grade corporate bonds, the return would be only around 7 per cent, before deducting the 1.4 per cent for management expenses.

Compounding the impact of aggressive asset allocation and the use of higher risk products, the local managed fund industry has a consistent record of overstating expected investment returns. For example, many of the retirement calculators available on investment websites have unrealistic assumptions as regards future returns.

A few years back, the widely publicised retirement savings booklet, Financial Passages, endorsed by the Retirement Commissioner, assumed in all of its savings calculations a 7 per cent real return - after tax, fees and inflation - when historic data clearly shows that in developed countries long term real returns struggle to exceed 2 per cent.

fxdrop 4,60 T he tendency to overestimate returns is repeated many times every day, when financial advisers make projections to potential investors based on the extraordinary returns recorded over the last five years. To do otherwise would in many cases be to acknowledge that their money would be better off left in the bank.

Unfortunately the fee/return tradeoff is tilted in favour of more risk in portfolios, and with the increasing complexity of the whole financial services sector it can be difficult to assess how appropriate your portfolio is for you.

Key issues for investors are:

* Take the time to understand your own portfolio's asset allocation profile and how it compares with that of the average pension fund: 40 per cent bonds, 10 per cent property, 50 per cent shares.

Whether or not you need the income from your portfolio is less relevant than your tolerance of losses. Many pension funds have little need for income yet bond weightings of 40 per cent are common. Most people over-estimate their risk tolerance, and having a substantial proportion of your money in bonds can reduce the temptation to sell when your other investments are down.

* In business, one of the key measures of a company's attractiveness is how much "free cash flow" it produces. Ditto for a savings plan - capital gains come and go but income is usually less volatile. Focus on cash returns after fees.

* Within each asset class, ensure that your investments are representative of that sector. Funds with names like "smaller this" and "emerging that" probably should not be a big part of your savings.

The net result of a higher risk asset allocation and returns that are not a great deal better than bank deposits, all overlaid with unrealistic expectations, can ultimately be disillusionment.

This could be the reason so many unit trust investors apparently sell out at the bottom. In 1995, financial adviser Spicers prepared a report showing that unit trust investors often become despondent in a bear market and sell out at the worst possible time.

Over-hyped expectations followed by disappointment can have that sort of effect on people.

* Brent Sheather is a Whakatane investment adviser.