New Zealand shares against the rest of the world

By BRENT SHEATHER

New Zealanders are said to be the world's greatest travellers - reflecting, some might say, how boring life is back home.

Similarly, local share investors tend to send a high proportion of their money overseas.

According to fund manager UBS Global Asset Management, investors in Australia, Britain and the US have an average of 40 per cent, 35 per cent and 19 per cent of their shareholdings outside their domestic markets. But here, according to Aon Consultants, at the end of September the average pension fund had shipped 69 per cent of its share portfolio to pastures greener.

Some of this is due to the dismal performance of New Zealand stocks and the scandalous behaviour of New Zealand executives in the past. It's also due to clever marketing by the local financial planning (as opposed to stockbroking) industry.

And, of course, investing overseas makes particular sense to New Zealanders because of the small size and narrow focus of the local market.

Even today, financial planners typically allocate 60 to 70 per cent of a retired investor's share portfolio to overseas stocks. Fund managers, financial planners and consultants have constructed highly profitable businesses selling the "invest offshore for growth" story on the basis that this will achieve higher returns and be less risky.

If they were making a sales pitch to retail clients, investment experts would use all the obvious arguments: New Zealand accounts for only 0.2 per cent of the world's stockmarkets; most of our executives were crooks, nitwits or both; growth industries such as technology, aerospace and pharmaceuticals are virtually absent locally.

They would then advise their clients to opt for lots of international fund managers. But things have changed - for the better locally and for the worse overseas.

A few years ago, when our currency was in perpetual decline, our local market dominated by risky forestry stocks, investment companies and property shares paid high cash dividends but earned no cash, overseas shares looked very attractive. But most of those companies are history so what is the right mix for Mum and Dad today?

The argument for investing overseas was often expressed in a graph which demonstrated that the most efficient portfolio in 1995 was 20 per cent in New Zealand shares and 80 per cent in global shares. The graph was courtesy of a US-based global fund manager.

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

In 1995 the historical statistics fitted the theory pretty well and complemented the marketing efforts wonderfully, but today the data has changed because:

* The riskiness of New Zealand shares - as measured by their volatility - has roughly halved in the past 10 years. The NZSE Gross Index is now about as volatile as an index of international shares.

* The 10-year return on New Zealand shares has almost doubled - from about 4 per cent a year in the decade to the end of 1995, to 7.5 per cent a year in the 10 years to the end of October this year. Meanwhile, the 10-year historical return from international shares has halved - from 11 per cent a year to 5.5 per cent a year over the same period.

The poor performance of global shares doesn't just reflect a strong New Zealand dollar; over that period the kiwi rose by only 1 per cent against the greenback.

* Overseas markets appear to have as many crooks and nitwits as we do. The US and Australia may have more.

Now, based on historical returns and volatility, the most efficient portfolio is around 20 per cent international shares and 80 per cent New Zealand. Admittedly, the data is historical and investment strategies should be based on expected future returns.

Even so, this reversal of fortunes is no doubt causing some discussion in pension fund circles. After all, for 10 years or so local fund managers - and, anecdotal evidence suggests, Mums and Dads too - have been cheerfully getting out of New Zealand shares, which then proceeded to outperform, in favour of international shares, which then underperformed.

Aon Consultants' monthly review of pension funds shows that, at the end of September, the average fund had 69 per cent of its shares overseas.

What is interesting about the Aon data is the wide range of views on the right balance between local and overseas shares. At one end of the scale, ASB Group Investments is hoping for the best with an 80 per cent overseas weighting. At the other end, BNZ Investment Management appears to be enamoured with the high dividends available locally and has opted for a 41 per cent weighting in New Zealand shares.

While professional fund managers appear to be divided, the NZ Superannuation Fund has no such doubts. It has opted for a truly heroic overseas weighting in its share portfolio - almost 90 per cent.

What possessed them to take such an outlying position? The fund took advice from the gurus at Mercer Investment Consulting and Mercer's impressive 117-page report says: "We used the risk and return expectations to determine an efficient allocation to NZ equities. The expected returns for overseas shares exceed those for NZ equities reflecting the faster economic and profit growth expected offshore.

"Risks were expected to be similar. Hedged overseas shares are expected to provide a further premium of returns and do so at lower risk. Mean variance optimisation based on these return expectations (none of which make any allowance for alpha) produced an efficient allocation of 5 per cent of the total portfolio (6 per cent of equities) to NZ shares."

OK that's pretty straightforward, but for the benefit of Mum and Dad in Tauranga, exactly why did you opt for 90 per cent overseas? The simple answer seems to be "because we think overseas shares are going to go up faster than New Zealand shares and we have too much money to invest it all locally anyway".

Paul Costello, chief executive of the NZ Super Fund, says that despite Mercer's view they expect similar returns from New Zealand and international shares, and the main consideration behind the asset allocation was the small size of the local market.

Expecting similar returns from New Zealand shares could be understating the attractiveness of the local stockmarket given that the return from shares should equal the dividend plus the growth rate of dividends. In New Zealand dividends are about 6 per cent where overseas they are less than 2 per cent. That is a huge head-start.

Even more worrying is that Mercer is apparently expecting an 8.4 per cent return from international shares for the next 20 years, which implies that dividends will grow by around 6.4 per cent a year.

An article in the Financial Analysts Journal last month shows that, in 16 countries last century, dividend growth has consistently been 2 per cent less than economic growth. Dividend growth of 6.4 per cent a year over 20 years from a passively managed portfolio of international stocks thus looks optimistic to say the least, but that is another story.

The 8.4 per cent total return assumption is also well ahead of that expected by many conservative forecasters. So we probably shouldn't follow the fund's example too closely. In fact, given its heavy weighting in shares generally (74 per cent) and international shares in particular, we can probably expect some back-pedalling before too long.

Given this range of views what should Mum and Dad do? For most people the answer will be academic as, unlike the Super Fund, they don't have billions to invest so their asset allocation will probably be constrained by their income needs.

The dividend income from international shares averages only about 2 per cent a year before fees, so one almost needs to be on the rich list (or an investment consultant) to be able to afford a meaningful exposure to those investments.

For example a $200,000 share portfolio invested one-third in New Zealand and two-thirds overseas would probably produce cash income of only 1.5 per cent or $3000 a year after management fees.

Of course the common practice locally is to conveniently assume that international shares will produce a steady stream of capital gains which can be systematically realised and the proceeds spent.

As we all know, the reality of the last few years has been quite different. On this basis, if security of income is a priority, international shares look a good deal riskier than what is on offer locally and across the ditch.

* Brent Sheather is a Whakatane investment adviser