Short pain for large gain

By TIM ANDERSON*

The Government Superannuation Fund revealed on Monday that it had lost what seems a staggering $315 million of its value in just three months.

This has prompted a knee-jerk response and concerted, if not ill-informed, debate from many quarters, including the Green Party, who accuse the Government of gambling with the life savings of public servants on overseas sharemarkets.

In a sense Greens finance spokesman Rod Donald is correct. Investing may seem to those outside the industry to be a gamble. Fortunately for the Government and public servants, this is one gamble (to keep the metaphor going) that is destined to pay off.

While $315 million is a considerable amount of money to lose, the reality is that a loss is not a loss unless you "crystallise" or realise that loss.

Seemingly backed into a corner, acting Finance Minister Trevor Mallard stated that "rebalancing will occur as a result of this".

"Clearly the New Zealand stock market is more attractive now relative to others compared with what it used to be," he said.

Unfortunately, Mr Mallard is employing the knee-jerk reaction typical of many first-time investors. You invest, you lose, you pull out, thus realising your losses.

In fact, many would argue that Mr Mallard has it around the wrong way: New Zealand equities may be cooling off and international equities are on the up.

But that is a short-term focus in what needs to be a long-term investment decision.

What is critical in this circumstance is to understand the essence of effective investing: the long-term benefits of diversification.

Spreading your assets, or investments, across a wide range of risk categories achieves the best risk-adjusted returns. In technical terms, diversification is used to determine an "efficient frontier" of risk-adjusted returns.

Diversification acknowledges the fact that in some years particular asset classes will outperform others. Looking at the graphic, it can be seen that the best-performing asset class changes almost yearly.

But it is no coincidence that for five of the last 10 years global shares have been the best performer.

For the previous 20 years, for example, the annualised return of international shares (as measured by the MSCI World Free Gross Index) is more than 14 per cent. Compare this with present long-term New Zealand Government stock, which matures in 2013, paying a mere 6 per cent.

This differential is potentially worth billions, not the $315 million that is in dispute at present.

Think of this scenario: Would a European investor with $1 million put it solely in a country that sits on the Pacific "ring of fire", is prone to earthquakes, whose economy relies heavily on dead animal byproducts and forestry, and is extremely overexposed in the case of a foot-and-mouth outbreak or similar? The answer is no.

The present allocation of the Government Super Fund is not radical or irresponsible. In fact, professional investors would argue that it is more irresponsible not to invest in international equities.

With an overseas allocation of 44 per cent, the Government fund is conservative compared with the asset allocation employed in much of the $40 billion managed fund industry in New Zealand.

Within a balanced portfolio, for example, an investor would expect to have 50 to 55 per cent in overseas equities.

Remembering that the time horizon of such a fund is realistically 30 to 50 years, whatever happens in any single three-month, six-month or even one-year period is largely irrelevant if the long-term objective is achieved.

The problems faced by the Government's fund are not unique.

Many managed funds are also going through the same pains because of a sustained bear market in international equities.

But the principles by which they invest, as advised by the reputable Frank Russell Company, are tried and tested. Long-term investors who stick to their plan will eventually win out.

* Tim Anderson heads FundSource Research, the investment strategy and managed fund research house. He can be contacted at tim.anderson@fundsource.co.nz