Spreading risk avoids being too closely tied to under-performing markets
The first quarter of 2010 has started very well for investors with the gains of 2009 continuing into the new year.
The world stock market is up by 6.3 per cent in the quarter, with the Australian market up by 6.8 per cent.
However, whereas Britain and Europe led the charge in 2009, this year America and Japan are outperforming, with gains of 8.4 per cent and 11.3 per cent respectively.
The under-performance of the UK and Europe in New Zealand dollar terms is partly due to foreign exchange effects - the pound and euro have weakened against the kiwi by 4.0 per cent and 3.8 per cent respectively in the three months.
So what worked best for investors in the first quarter? The no-brainer approach to global equity investing - that is, via a global equity index fund - paid off with its neutral weighting of about 50 per cent in US stocks delivering the goods with a 6.3 per cent return before fees.
Of course active fund managers will tell you that you could have done even better by underweighting Europe/UK and overweighting the US and Japan.
The latest quarter from Japanese equities sounds good, but is just one small bit of good news in what has been almost 25 years of disappointment from Japanese equities.
If you were unlucky enough to have bought into the Japan story at its peak in February 1989, when it made up about 50 per cent of the world stock market you would, 21 years later, still be looking at a 28.5 per cent loss in yen terms.
Further up the risk curve, emerging markets might be the flavour of the month but at 5.6 per cent they actually underperformed developed markets in the first quarter.
New Zealand shares had a relatively bad quarter, falling by 0.1 per cent.
No prizes for guessing the biggest contributor to that bad result. Yes, it was Telecom again, off by 10.8 per cent in the quarter.
The company's 10-year performance is an embarrassing -4.9 per cent a year.
Much of Telecom shareholders' long-term suffering can be attributed to the directors' decision to invest in the Australian telecom sector at the top of the market some years ago.
It would be interesting to revisit the assumptions the directors originally made to evaluate the economics of this investment which, to my knowledge, has never made a profit.
Surprisingly, bonds had a reasonable quarter, particularly New Zealand ones (+2.3 per cent). This is surprising for two reasons.
Firstly, at the start of the year brokers were telling their clients to keep portfolio maturity short because interest rates were going to rise.
In fact they actually fell - long-dated 2020 Transpower bonds started the year yielding 7.3 per cent but were down to 6.9 per cent by March 31 giving investors a handy 3.2 per cent return in the quarter.
The second source of surprise was the fact that overseas government bond prices were stable at the same time that shares did particularly well.
Usually when shares go up bonds go down, and vice versa, because buoyant economies are associated with more demand for credit, higher economic growth rates and the risk of higher inflation.
Conversely, government bond investors thrive on bad news - slower economic growth and falling prices.
The strength in both bonds and shares in the first quarter may be due to the dire state of many governments' finances in that the market perceives that the best way out of the debt mire is higher rates of economic growth, which means higher tax receipts and thus a better chance of paying off debt.
With sluggish economies (everywhere except the emerging markets and Australia), western governments appear to be gambling that by keeping short-term interest rates lower for longer that this revives their economies sufficiently for economic growth to underwrite higher taxes down the line.
What all these numbers mean for the man in the street with a typical balanced portfolio, comprising 40 per cent bonds, and 60 per cent shares is a return in the quarter of 2.6 per cent before fees and tax. This might sound modest but compounded over four quarters and you get 10.8 per cent.
For some perspective in the past 12 months, a typical balanced portfolio will have returned an impressive 17.6 per cent before fees and taxes. This is, however, well ahead of expected returns which, for a balanced portfolio today, will be around 8.0 per cent a year pre-tax, pre-fees.
Longer term the 10-year performance of a balanced portfolio has been just 2.7 per cent a year reflecting the poor performance of international shares over that period (-3.0 per cent a year in New Zealand dollar terms).
The 10-year return from a balanced portfolio is considerably worse than 90 day bills (+6.5 per cent a year), government bonds (+6.8 per cent a year) and the New Zealand stock market (+6.7 per cent a year).
The good news for those starting out with a savings scheme like KiwiSaver is that because international shares exhibit "serial negative correlation" - a period of poor performance is frequently followed by a period of good performance - rewards from international shares should be a lot better in the next 10 years.
So what do investors do now? Barclays Capital's March Global Outlook argues that there is no reason to sell shares at present despite the strong gains as "the combination of economic recovery, near zero short-term rates and financial deleveraging in the private sector is a potent brew for asset prices".
Barclays strategists give the thumbs-up for shares but are negative on government bonds.
With 10-year US government bonds paying just 3.8 per cent and those in the UK 4.0 per cent, it is not hard to see why. These rates are historically low and just a whiff of inflation could see bond investors head for the hills.
Because interest rates are low an increase of just 1.0 per cent to 4.6 per cent in the US on a 10-year bond would mean a capital loss of 15.1 per cent.
The situation looks a bit different here in New Zealand - 10-year government bonds are yielding 5.9 per cent and, according to Global Investment Returns Yearbook, the average long-term bond return from 1900 to 2009 was 5.8 per cent a year.
Inflation averaged 3.7 per cent a year so the real bond return was 2.0 per cent a year. If inflation is 3.0 per cent a year, our longer-dated bonds represent fair value and a good insurance policy against a double-dip recession.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
