Brent Sheather: Balanced portfolios reap rewards at last

Despite natural disasters markets have seen a glimmer of hope. Photo / Christine Cornege.

Looking back at the first quarter of the year it seems to have been three months of one disaster after another. While the catastrophes in Christchurch and Japan and the wars in the Middle East made the headlines, the stockmarket, if it is in the right mood, is able to look past the immediate future and take the long-term view.

Sharemarkets have been in a manic state for some time. Buoyed by rising company profits and low interest rates, global equities had a vintage quarter returning 7.1 per cent in New Zealand dollar terms. It is not often that one gets a year's expected return in three months so we should savour the moment.

The highlights were Europe, where stock prices surged by 8.8 per cent, closely followed by US shares, which returned 8.2 per cent. What dragged the world index down was the poor performance of the Japanese stock market, which fell 10 per cent in the month of March to be down 2.9 per cent in the quarter.

For a change the Australian, New Zealand and Asian markets lagged the larger Western bourses returning 7.3 per cent, 3.9 per cent and 3.5 per cent respectively. Several astute commentators in January made the point that valuations in the emerging economies had been bid up to above that of the developed markets, making the latter relatively attractive, and subsequent performance has borne this out.

The good news is balanced funds typically have about 50 per cent of their assets in shares, two-thirds of which are in the developed economies, and this will have underwritten returns in the quarter.

In addition your average balanced pension or KiwiSaver fund will have 40 per cent of its money in bonds split evenly between New Zealand and overseas and here, too, returns were above normal with global government bonds returning 3.3 per cent and NZ government bonds returning 2.2 per cent. In contrast to the last quarter, when the New Zealand dollar was strong - up by 15 per cent against the euro, for example - this quarter saw a much weaker kiwi dollar. This was a big factor assisting returns for local investors where the kiwi dollar fell by a whopping 7.6 per cent against the euro, 3.4 per cent against the aussie and 2 per cent against the greenback.

So what does it mean for the average balanced fund? Assuming 40 per cent in bonds and 60 per cent in growth assets, the average balanced fund will have returned about 4.4 per cent in the quarter, pre tax and fees, which compares very favourably with the 1 per cent or so investors would have earned in the bank. This outperformance of a balanced portfolio over cash is welcome, rational and long overdue.

But looking back over 10 years, investors in a diversified fund have not been adequately compensated for the extra risk they took. Six-month term deposits have returned about 6 per cent a year pre tax over the past 10 years, which is well ahead of a balanced portfolio estimated to have returned 3.8 per cent a year pre tax and pre fees. Knock 2-3 per cent a year off in fees and many local investment portfolios are likely to be worth less than they were 10 years ago, particularly if their owners have been using the income to live on.

Since 2000 quarterly returns have been volatile with the best return being in the quarter ended March 2006, when a balanced portfolio earned 9.1 per cent, and the worst quarter being that which ended March 2009, when the return was -6.5 per cent.

A feature of the quarter is the relative outperformance of developed markets over developing markets. This is likely to have surprised many investors, including Gold Coast Private Wealth Specialist Goldman Lostchild, which we reported in December was overweight in emerging markets and underweight in the US. It appears Goldman Lostchild's view was widely held, as anecdotal evidence suggests back in December many investors were beguiled by the historic outperformance of emerging markets and their growth prospects.

It is important, however, not to confuse economic growth with stock market returns as in the latest Global Investment Returns Yearbook the authors show there is little or no correlation between the two.

London economics consulting group Longview Economics says as long as there is no further spike in the oil price, the US economic recovery looks increasingly assured on the back of strong corporate cash flows and good labour productivity. While other economic consulting groups such as Smither's and Co see US corporate profitability falling, Longview says it's normal for profitability to rise sharply after a recession and level off as labour costs rise. Smither's maintains the US government must eventually cut its spending to reduce the deficit and this will mean lower profits for US companies.

It is normal at the end of the quarter to speculate as to where best to place your money for the next 12 months, with the most extreme form of this optimistic behaviour being to try to pick 10 outperforming stocks when all the theory and common sense says to stay diversified. The trade-off between concentration of funds to get higher returns is higher risk and as the Financial Times has argued recently, specialisation represents a disservice to most retail investors.

The FT argues that specialisation, like recommending BHP and Rio Tinto as opposed to just buying the whole Australian stock market, primarily serves the needs of the financial services industry providers rather than its customers. Most people don't realise that betting on one sector is risky, costs a lot more and is almost impossible to get right. But it is good for business - once you have your client into a strategy of picking stocks, it's relatively easy to get them to trade out of where they are and into something else. The alternative, owning everything, means the need to trade is much reduced.

Many clients look for this sort of advice but the reality is one of the biggest threats to an individual retail investor's wealth is the adviser who forsakes diversification to overweight the asset class or stock that they think is going to outperform. Unless you are Warren Buffett, you inevitably follow the crowd, buying things after they have gone up or selling things after they have gone down.

Institutional investors, however, are clever - their advertising suggests to their retail clients that they have the capacity to discern the future and tilt their portfolios accordingly. However, most are scared to take a big position away from the benchmark and risk losing their job.

On a completely different subject we are seeing a rash of takeovers and internalisations of property companies happening on the New Zealand bourse. It seems like the "independent experts" who are supposed to give the shareholders of the target company advice almost always seem to give the thumbs-up to the takeover. I put this question to one "independent expert" firm, which rejected the notion, but neither was it prepared to provide the statistics showing just how often it gives the go-ahead to takeovers. New Zealand really could use a few more genuinely independent directors prepared to stand up and look after the interests of minorities.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free.