How do claims about expected returns stack up against the numbers?
Fund managers as a whole are a resilient bunch. Even though academic paper after paper concludes that most active managers underperform the market index, that doesn't deter them from regularly going public denying the fact.
In a recent newspaper article, a local fund manager made the following comments:
1. "The long-run trend for NZ equities is for returns of 9-12 per cent a year. That is what you would expect from a passive manager."
2. "An active manager should expect to do 2-4 per cent a year better than that. That is 11-16 per cent a year or so over a long time frame."
The fund manager then decried the tendency of New Zealanders to attack fund managers.
He contrasted this behaviour, which he regards as a peculiarly New Zealand trait, with that of the investing public in the UK and US, where savings planning is better accepted and by implication where fund managers are held in higher regard.
So should we feel sorry for local fund managers and give them our money to make them feel better? Or is the fund manager looking at the world through rose-tinted spectacles. This is clearly a case for the statistics police. Their report follows, using expert witnesses from New Zealand and overseas:
* 1. The defendant stated that "the long-run return expected from a NZ index fund is 9 per cent - 12 per cent". In fact in the 10 years ended December 31, 2009, the actual pre-tax, pre-fee return of the New Zealand stock market index was 6.2 per cent a year, over 20 years it was 7.2 per cent a year and since 1928 it has averaged 9.6 per cent a year.
Take 1 per cent a year off that for the expenses typical of a New Zealand index fund like SmartFONZ and you are left with a range of 5.2 per cent to 8.6 per cent.
But the long-term return of 8.6 per cent could be overstating things a little as dividends back in 1928 are likely to have been higher than now. We also know that r = d + g; that is, the return of a share is equal to its starting dividend plus the rate at which dividends grow.
Thanks to research by Robert Arnott and others we know that the historic long-term return from US stocks is in no way indicative of future returns as dividends were much higher at the start of the period and US shares have become more expensive.
Today, the dividend yield on New Zealand stocks is probably around 5 per cent and, according to another article by Robert Arnott, growth in dividends for American stocks has averaged 2 per cent less than underlying economic growth.
So with long-run nominal GNP growth at 5 per cent or 6 per cent a year, the long-run return from a New Zealand share index fund is going to be something like d (5 per cent) plus 6 per cent minus 2 per cent minus 1 per cent, equals 8 per cent, just about the mid-point of our historic data and quite a way off the high point of the defendant's estimate of 12 per cent.
"We find the defendant guilty of overestimating returns, a favourite pastime of fund managers, financial planners and just about everybody else associated with the savings industry - far easier to justify 2 per cent a year in fees if the market is going to return you 16 per cent a year than 8 per cent a year. When eventually confronted with the reality of 7 per cent or 8 per cent less 2 per cent for fees, it doesn't take Mum and Dad too long to work out that they are getting, after fees, the return of bank deposits with the risk of equities."
Another way to calculate the prospective return on shares is to calculate the equity risk premium. This is the extra return we can expect from shares over bonds. Dimson, Marsh and Staunton (DMS), three professors from the London Business School, have done a bit of work on this subject.
Without going into too much detail, DMS conclude that in the next 100 years international shares will probably outperform international bonds by about 3 per cent a year. In New Zealand, 10-year Government bonds yield about 5.8 per cent, so on DMS' analysis of prospective returns from shares, before fees and tax will be about 8.8 per cent a year.
* 2. Next up is the defendant's statement that "an active manager should expect 2-4 per cent a year better than that". As we know people can expect to do anything they like but reality doesn't always coincide with expectations.
One of the most respected studies of mutual fund returns was a 20-year analysis by Professor Mark Cahart, published in the Journal of Finance in March 1997, in which he concluded that "expenses have at least a one for one negative return impact on fund performance and that turnover also negatively impacts performance".
A second, recently updated study by Professor Eugene Fama of the University of Chicago, entitled "Luck Versus Skill In The Cross Section Of Mutual Fund Returns", studied a period of 22 years and showed that the number of managers consistently outperforming the index is so small as to be almost entirely due to luck.
So that's overseas markets dealt with. Why should New Zealand be any different?
In a depositions hearing the accused cited in his defence the long-term performance of his firm's New Zealand equity fund which apparently has exceeded the New Zealand stockmarket index by about 4.5 per cent a year over 10 years.
He also referred to a Mercer survey which showed that the average excess performance of the New Zealand equity managers surveyed has been around 3 per cent a year since 1999.
The statistics police then reviewed Fund Source data which showed that the average New Zealand equity (active) fund returned 30 per cent in the 12 months ended December 2009 and 9.7 per cent a year in the seven years ended December 31, 2009.
This is well ahead of the NZSE Gross Index which returned 19.2 per cent a year in the 12 months and 7.4 per cent a year over seven years.
As noted above, this data is in sharp contrast to the experience in the US, UK and Europe. So does it mean that New Zealand somehow has been endowed with gifted fund managers? That's what the data apparently says, but there are three likely explanations for the outperformance, none of which relates to skill.
First up is Telecom NZ. Telecom has up until recently been far and away New Zealand's largest company, representing up to 35 per cent of the NZ Gross Index. At the same time, as we all know, Telecom has been a poor performer returning minus 2.7 per cent over 10 years versus plus 7.0 per cent for the index including Telecom.
New Zealand fund managers are traditionally underweight in Telecom shares purely from a risk control perspective, with an average 10 per cent to 15 per cent weighting. This has had the very pleasant side-effect of making New Zealand fund managers appear index beaters.
With the relative decline in Telecom's capitalisation it is now only the second largest company behind Fletcher Building and represents 13.9 per cent of the NZSE All Index.
At the same time its performance has improved - in the year ended December 31, 2009, Telecom outperformed the index by 1.0 per cent, although with the XT network problems 2010 is not looking so good.
The second factor assisting NZ fund managers has been their tendency to invest some of their New Zealand equity fund in New Zealand-listed Australian stocks like ANZ and Westpac, or in Australian shares directly, like BHP.
Australia is the best-performing major stockmarket in the Global Investment Returns Yearbook in the period 1900-2008 and resource stocks like BHP and banks like Westpac have led the Australian market.
New Zealand doesn't have a local banking sector so fund managers frequently get exposure to this sector via ANZ/Westpac. This is particularly fortunate as Westpac returned 64 per cent in the 12 months ended December 31, 2009, and has returned 12.8 per cent a year in the past 10 years.
The third reason is that the NZ Gross Index is dominated by the big stocks - Telecom, Fletcher Building, Auckland International Airport, etc, but of the Fund Source sample of 14 funds which have been going for seven years or more, five are specialist small company funds.
The NZX Small Company Index has substantially outperformed the large company index over the past seven years - the Telecom effect again.
The statistics police advise that a "not guilty" verdict looks appropriate on the second point with the caveat that while New Zealand fund managers as a whole have outperformed the index, the outperformance may in many cases be due to the one-off underperformance and high weighting of Telecom in the index and/or the mis-specification of the benchmark index. Therefore past performance may not be indicative of future performance.
To be fair, though, whatever the technicalities, it appears that New Zealand fund managers have done a pretty good job in the past. Given the problems that frequently plague retail investors, managed funds, both active and passive, make sense for at least part of most people's New Zealand share portfolios.
* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available free on request.
