KEY POINTS:
The dreadful performance of the world's sharemarkets last year clearly demonstrates the importance of having flexible and diversified investment portfolios.
Individuals who adopted these prudent strategies, a number of which are covered below, would have avoided the worst of the carnage but those who invested all their money in sharemarkets - and took a passive approach to this asset class - would have had a dreadful year.
As the accompanying table shows, all of the world's major markets had negative returns, with the MSCI World Gross Index falling 38.3 per cent in local currency terms and 40.3 per cent when translated into US dollars (gross performances include capital and dividends).
The UK market was the best performer, in local currency terms, with a negative return of only 28.5 per cent; Ireland and Russia were the worst, with declines of 70.2 per cent and 72.2 per cent respectively (the four largest emerging markets - Brazil, Russia, India and China - are also included in the table).
According to MSCI the NZX had a negative gross return of 38.6 per cent in local currency terms, which placed it at the top end of the world rankings.
However, when converted to US dollars, the NZX fell by 53.3 per cent. The UK, Canada and Australia were also hit by weak currencies.
Tunisia, with a gross return of 1.3 per cent in its local currency, was the only market with a positive 2008 year return among the 60-plus covered by MSCI.
The first point to note about last year is that a number of asset classes had positive returns, including New Zealand government bonds, which were up 15.7 per cent, NZ corporate bonds 14.4 per cent, NZ cash 8 per cent and overseas cash 35.6 per cent on the basis of equal holdings in US dollars, Australian dollars, euros and Japanese yen.
Thus a portfolio consisting of 50 per cent of the MSCI New Zealand sharemarket gross index, 15 per cent NZ government bonds, 15 per cent NZ corporate bonds, 15 per cent overseas cash and 5 per cent NZ cash would have had a negative return of about 9 per cent.
This is a long way from the MSCI NZX negative return of 38.6 per cent and shows the importance of having a flexible and diversified investment style.
There are also a number of different strategies that investors can adopt towards the equities portion of their portfolio.
Equities are usually the largest and most important asset class as far as the overall return of a portfolio is concerned.
The three main approaches towards sharemarket investment are:
A passive style where portfolios are usually determined by the composition of an index.
A relative approach where the equities allocation is fully invested and the objective is to outperform a benchmark index.
An absolute strategy, which is where the investment manager can move in and out of equities depending on the market outlook. The main objective of an absolute fund is to achieve a targeted return regardless of the sharemarket's performance.
In general terms, the passive approach produced dreadful returns last year, while a number of absolute funds significantly outperformed the sharemarket indices because this investment style is more suited to difficult market conditions.
One of the largest passive fund managers in New Zealand is Smartshares, which is operated by the New Zealand Exchange. Smartshares has five public funds which are linked to the NZX 10 Index, NZX Midcap Index, NZX Portfolio Index, Australian S&P/ASX Mid Cap 50 Index and the Australian S&P/ASX 20 Index.
An investor who buys into a passive fund gets a portfolio that exactly mirrors the holdings and weightings of companies included in a particular index.
Managers do not pick individual stocks, they accept the returns generated by the index they choose to mirror.
Thus last year the NZX Portfolio Index declined by 31.4 per cent and smartFONZ, which is the Smartshares fund that mirrors this index, produced a similar result before fees (the NZX Portfolio Index performed slightly better than the MSCI New Zealand Index last year because the latter had a higher weighting towards large, poorly performing companies).
One of the arguments in favour of passive funds is that the fees are low because investment managers are not required to make any decisions.
This low fee structure is a myth as far as the smartFONZ, Smartshares' NZX Portfolio Index fund is concerned, as fees are 0.75 per cent for holders of between 2000 and 399,999 units. This is not much lower than active funds.
This column, in contrast with fellow Herald columnist Mary Holm, is not a fan of passive funds. Passive funds have consistently underperformed active funds in New Zealand and the gap widened last year.
Slightly lower management fees do not compensate for the inferior returns generated by passive funds.
The relative approach is where a fund is usually fully invested in equities and managers are trying to outperform a sharemarket index.
For example, fund managers who are benchmarked against the NZX Portfolio Index and achieved a negative return of 24 per cent last year compared with a negative 31.4 per cent by the index, would have been relatively happy with their performance.
There are two main types of relative fund managers, those with a buy-and- hold approach and those who trade their portfolios more aggressively.
The new PIE regime is more beneficial to the latter approach and this style seemed to produce better returns than the buy-and-hold method last year.
The main challenge for relative fund managers is choosing the correct stocks for their portfolios, although they often have the option to hold up to 30 per cent in cash if they believe the overall market outlook is uncertain.
The relative approach, which is the most commonly used strategy in New Zealand, is slightly more costly than the passive approach in terms of fees.
The final option, which is the absolute style, encourages investment managers to make two decisions. These are individual stock selection and the outlook for the different asset classes.
If managers believe the short-term outlook for bonds, NZ cash and overseas cash is better than shares, then they can reduce their holdings in equities and increase their exposure to these other asset classes. Absolute fund managers who took a negative view of the sharemarket and had exposure to these other asset classes performed much better than passive and relative managers last year.
Absolute funds usually have a clearly defined performance target, either to achieve returns of more than 10 per cent a year or to outperform the 90-day bill rate, regardless of sharemarket conditions. Their fees are slightly higher because absolute managers are required to make asset allocation, as well as stock selection, decisions.
But absolute fees in New Zealand are usually no more than 1 per cent to 1.5 per cent a year, although an extra performance fee is frequently levied if the targeted return is exceeded.
Absolute funds are much more popular in the United States than in New Zealand, even though they are ideally suited to volatile market conditions and for KiwiSaver investors who seem to prefer either income, balanced or relative style equities funds at present.
New Zealand investors, including those with KiwiSaver accounts, should take a closer look at absolute funds because they give investors the opportunity to take part in sharemarket gains but also have the potential to protect them against sharp downturns if managers correctly anticipate adverse sharemarket movements.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management and manages a relative fund, the Milford Peak Fund, and an absolute fund, the Milford Aggressive Fund.
bgaynor@milfordasset.com
