Mark Lister: Portfolio fault line lies in NZ's shaky nature

Two major events, the failure of South Canterbury Finance and the Christchurch earthquake, have provided investors with unequivocal evidence of the importance of diversification.

With what's happened in the finance company sector over recent years, we all recognise fixed income must be invested carefully, diversified as much as possible, and, at times, a bit of return has to be given up to get more security. That's the cost of sleeping well at night.

The Christchurch earthquake provides another stark lesson for New Zealand investors. Only a few weeks ago, in late July, we wrote a report for clients about the real risk of natural disasters in New Zealand.

We argued in the note the unthinkable - like a major volcanic eruption, an earthquake or the outbreak of a disease that devastates our farming sector - can happen, and that investors should be prepared for such an outcome. The best protection against "New Zealand" risk is to diversify your portfolio to include global assets. We are going to argue that point again.

The human and financial impact on Christchurch of the earthquake has clearly been devastating. The effect on markets, though, has been modest. The share prices of construction stocks gained a few per cent and of insurers fell a little. The NZ dollar appreciated slightly when it could have been expected to fall.

The final cost of the quake is estimated to be anywhere from $2 billion to $4.5 billion. With the quake happening at a time when the economy, and especially the construction sector, was slowing down, the rebuild can be viewed as a form of government stimulus that may actually have a positive impact on GDP growth as spare capacity is put to work on reconstruction.

But the lesson from the quake for investors is loud and clear. New Zealand is vulnerable to natural disasters. Investors must build this risk into their investment strategy.

In our July report we pointed to the implications for investors of a recent study into the Taupo volcanic zone from the Institute of Geological and Nuclear Sciences published in the NZ Journal of Geology and Geophysics.

According to this study, the entire central region stretching through to the Bay of Plenty is one of the most active volcanic regions in the world with 12 active volcanoes and over 30 geothermal hotspots. Taupo itself is a massive volcanic crater 20km in diameter, making it one of the 10 largest in the world.

The first eruption at Taupo occurred 27,000 years ago and it has had 29 major eruptions since. The last big blow was in AD 181. This eruption was huge and one of the largest the world has seen over the past 5000 years. It is estimated that 100km3 of material was ejected in this eruption - a third of which was expelled in just a few minutes. Scientists believe the eruption column would have been 50km high. Ash was sent around the world with both the Romans and Chinese writing about an unusual sky colour and atmospheric conditions at the time.

The problem we now have is Taupo has erupted every 700 years on average and, with the last decent eruption 1700 years ago, it's clearly overdue. One of the report's authors was quick to point out averages are meaningless in geological terms. We take his point. The next eruption could be in three days, three months, three years, 300 or 3000 years, all of which are largely indistinguishable on a geological calendar.

But what if another major eruption occurred at Taupo? The scientists estimate the North Island would be heavily damaged and everything would be affected, starting with air travel. Auckland is broadly downwind, and more so if Mt Taranaki decides to join the party. Ash would cover a wide area, the region around the volcano would be completely devastated and farming would become impossible for a period of time. Some areas of the North Island would become uninhabitable.

In economic terms, GDP would shrink drastically as tourism, trade and commerce grind to a standstill, interest rates would be reduced to very low levels and our currency would fall sharply. Some will argue this discussion is pointless. First, the odds of this happening are very low, second, the effects might not be as bad as we expect and third, if it does happen, we will have more to worry about than our portfolios.

We disagree. Investment advisers are supposed to worry about risk. And the fact New Zealand is a small country that straddles one of the most active fault lines in the world is worth worrying about. Not only is New Zealand vulnerable to natural disasters, but also to an outbreak of a disease that threatens our all-important agriculture sector.

The unthinkable can happen, and investors should be prepared. Our country's volcanic geology is a factor New Zealand investors should consider when they are deciding on the asset allocation of their portfolios.

We have long recommended clients diversify some of their investments outside New Zealand. Over recent years, however, there has been a shopping list of rational reasons why investing overseas has been a bad idea.

The New Zealand dollar has been exceptionally strong, our share market has done better than most other global markets, our interest rates are higher than overseas, imputation credits are not available on overseas shares and the Fair Dividend Rate tax rules on global share investments are ridiculously complex.

Despite all of this, we still believe it is important to have a proportion of a portfolio invested outside New Zealand, as well as across asset classes. The 2009 World Wealth Report from Capgemini and Merrill Lynch clearly shows diversification is something people with serious money take very seriously.

This survey of high net wealth investors - defined as those who have US$1 million ($1.3 million) of net financial wealth (in addition to their home) - outlines where these people invest their money.

On average, the 10 million people globally that fit this definition of having high net wealth have 29 per cent of their investment capital invested in shares, 30 per cent in bonds, 17 per cent in cash, 18 per cent in real estate and 6 per cent in alternatives like hedge funds, commodities and private equity.

If the world's richest people take such a diversified approach, perhaps the rest of us should also consider it. Not only are these people diversified across asset classes, but we would also hazard a guess that they don't have all of their assets invested in New Zealand. In fact, we infer from the available data from this report that these investors have about 40 per cent to 50 per cent of their investment portfolios invested outside their home markets.

These days it is very easy to buy overseas shares. Investors can buy funds such as index funds or UK investment trusts, a handful of which are listed on the New Zealand market, or they can put together a portfolio of global companies.

Whether to hedge the currency or not is a very topical issue. Investors with a high proportion of their portfolio invested overseas may want to hedge some of their currency risk to protect their portfolio against rises in the New Zealand dollar.

However, smaller allocations to global assets should generally be left un-hedged, as having exposure to overseas currencies is a key protection against an event that causes our currency to fall sharply.

New Zealand is a wonderful place, but a small place. It is therefore prudent to carry some form of country insurance, and we regard offshore holdings as insurance against "New Zealand risk".

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column should not be regarded as specific investment advice.