We're a long way from the crazy days of the Dutch tulip mania. Photo / File
OPINION:
Q: We are saving via a small basket of shares as a long-term investment, including a couple of managed funds and an index fund. I appreciate your advice that it's the best way for an amateur to invest.
However, given more and more amateurs investing in the sharemarket via KiwiSaver, Sharesies or otherwise, is there a chance of these funds becoming overvalued because of popular appeal? Particularly in New Zealand where there's only a fairly small range of products available.
What is there to stop the well-meaning amateur from buying shares in a well-marketed fund for a high price that actually only holds minimal assets and has much less real value? Are we at risk of buying tulips?
A: If you're saying that a fund might not hold the shares it says it holds, that's highly unlikely. All New Zealand funds — KiwiSaver or not — are overseen by licensed supervisors. And both the fund managers and the supervisors are watched over by the Financial Markets Authority.
But I think your worry is that the shares in the funds might be over-valued.
We're certainly not in Dutch tulip mania territory — as in the 1630s when, according to Wikipedia, single bulbs sold for more than 10 times a skilled artisan's annual income.
Extraordinary.
However, it's true that whenever the sharemarkets zoom upwards — as they have in the last few months, despite a recent dip — there is a risk that shares are overvalued. In the end there is always a "correction". But — in the longer end — the markets always recover.
Let's look at the alternatives. Bank term deposits and lower-risk funds are bringing in low returns. And property is perhaps as overvalued as shares.
As long as you don't plan to spend the money within, say, 10 years, I think it's best to leave it in funds that hold shares. That's where my long-term savings are.
Don't try to work out when it's best to get in and out of shares. That's usually a losing strategy, and much more worrying. For an example of what can happen if you drop out for a while, read on.
Q: Please would you let us know your thoughts on Michael Burry's view that ETFs and index funds are the next bubble? Have just invested a fair bit through InvestNow and Simplicity.
Here is the CNBC article.
A: First, for the sake of other readers, exchange traded funds (ETFs) and index funds are known as passive funds, because their managers simply buy all the shares in a market index. They don't trade shares unless the index changes.
Meanwhile, active funds' managers select and trade shares they think will perform well.
Passive funds have been around for decades — and I've been recommending them for almost that long. But they have become much more popular, especially in the US, in recent years.
Your article quotes Michael Burry, who "shot to fame by betting against mortgage securities before the 2008 crisis. Burry was depicted in Michael Lewis' book The Big Short and the subsequent Oscar-winning movie of the same name." The key points of the article are:
• "Passive investments are inflating stock and bond prices in a similar way that collateralised debt obligations did for subprime mortgages more than 10 years ago, Burry told Bloomberg News."
• "'Like most bubbles, the longer it goes on, the worse the crash will be,' said Burry."
I asked Dean Anderson, founder and CEO of Kernel Wealth and a big fan of passive investing, for comment.
"First, let's make clear that index funds and ETFs are nothing like a collateralised debt obligation (CDO)," he says. "CDOs are a type of derivative, with their value coming from the value of other assets. In the case Michael Burry is referencing, it's sub-prime mortgages." These turned out to be terrible investments in the global financial crisis.
"Meanwhile, the vast majority of index funds and ETFs track broad equity market indexes, holding shares directly in multiple companies across a range of sectors. Most of these companies will be successful and provide long-term growth to investors. This will offset any single company failure that occurs from time to time." Index funds have not caused bubbles, he says.
"One thing Michael, and many active managers, seem to get confused about is asset ownership versus trading." Index funds typically trade about 7 to 8 per cent of the value of the fund each year, compared with "often over 100 per cent in actively managed funds. This is important, because it is the last traded share that sets the value of the entire company.
"So, while index funds may own 30-40 per cent of the US equity market (about 5 per cent globally), they account for an estimated 10 per cent of trading volume, so the impact on company values is negligible."
He adds that "there are hundreds of index funds, tracking a range of indices — at any point in time some may be buying shares in a company and others selling.
"Does this mean parts of the market aren't in a bubble? No. By its very definition, we can't see a bubble till it has burst!" Low interest rates have pushed term deposit holders into other investments, including shares. And higher demand — from direct investors and those in both active and passive funds — has pushed up prices. But it "isn't an active versus index story".
Anderson adds that a low-fee, well diversified index fund "seems like the best pick for my money right now. That way I am not concerned if one company goes bust, if a part of the market is a bit expensive, or relying on an active manager to try and forecast a bubble, ultimately to once again mis-time the market and underperform.
"Stay invested, regularly contribute and you maximise your chances of long-term financial success." Sounds a bit like what I said above!
Footnote 1: On mis-timing markets, I suspect you didn't notice the Burry article was written in September 2019.
In the one-and-a-half years since then, ETFs, index funds and most other share funds have gone through a huge Covid-related downturn, then an extraordinarily quick recovery.
The result: the MSCI world share index is now 27 per cent higher than in mid-September 2019. And the New Zealand sharemarket is 13 per cent higher.
If you had bailed out of a share fund after reading the article, imagine how you would feel now.
Footnote 2: History is full of people like Michael Burry, who get their market timing famously right. Next time they are usually badly wrong.
Q: I think a lot of people are like the person last week with about $300,000 to invest, especially if they have considerable bank deposits. As those come due, the investor will certainly be looking for somewhere else to put the money.
The only problem with those low-risk funds you're talking about is that they, too, have a major portion of their investments in banks, and the returns on a number of them have gone down in the last year.
I'm sure that will continue as more investments come due and they have to reinvest at a very low interest rate. So are these funds really much different from having money in the bank?
A: Some are. The lowest-risk funds in Sorted's KiwiSaver Fund Finder — called defensive funds — include:
• Cash funds, whose investments are mainly bank term deposits or similar. And you're right, their returns have tended to fall — although not always. See "show yearly returns" in the details about each fund.
• Funds with "bonds", "income", "fixed interest" or similar in their names. If you look at their holdings, you'll see more bonds than cash. The returns on these funds are a bit more volatile, but higher on average.
Despite what the next correspondent says, higher risk and higher return go together.
Q: Let's explore your comments last week that to obtain higher returns, one needs to assume higher risk.
Returns must be separated as to cash dividends and capital appreciation.
As bond yields and term deposits have fallen from 8 per cent, we have progressively invested online in a handful of listed domestic businesses with a strong economic franchise — regulated monopolies and utilities like businesses of scale, which provided high dividend yield, strong dividend growth and a price containing a significant margin of safety.
These offer the lowest possible risk profile and highest possible cash returns.
No foreign exchange exposure, FIF tax, state or federal taxes, depository fees, capital gains tax, brokerage, funds management fees, but full imputation credits.
This minimum risk investment portfolio now delivers dividends of 6.3 per cent gross and IRR [internal rate of return] returns in excess of 16 per cent.
Managed fund returns with much higher risk strategies should be delivering substantially higher returns. Yet this does not appear to be the case — most delivering equivalent pre-tax, after-fees returns in single figures.
Is my logic faulty, or is the higher risk higher, returns mantra incorrect?
A: I'm sticking with the mantra. I've been watching for decades now, and I've never seen an investment with a high return that wasn't risky.
But let's say you've discovered the holy grail — a low-risk, high-return investment. Surely many of the people who follow investments for a living will also learn about it. They will rush to invest, and as demand soars, so do prices. Sellers of in-demand shares are not idiots!
Higher prices reduce returns. The dividends investors receive are a lower percentage of what they paid. And their capital gain will be smaller.
So you've got to get in at the start. And it would be a lucky person, indeed, who was the first to discover more than a few low-risk, high-return investments.
Turning to your shares, your returns are good. But I suspect that means your investments are riskier than you realise.
I remember a friend rather smugly telling me, years ago, how the dividends on his rock-solid share were much higher than bank interest rates. They had been that way for years during a relatively strong economic period. Suddenly, to his dismay, business conditions deteriorated and dividends were slashed. And of course the share price followed downwards.
Meanwhile, my short-term money in bank deposits maintained its returns.
Q: Having long-term rentals, in my view, is the optimum situation for both landlord and tenant, providing of course the agreement is clear and both sides stick to it.
After a series of disasters, we were pleased to find "reliable" long-term tenants for both houses. After six months, tenant one said, "Love it here, you will have to carry me out in a box, but I need a workshop so I can work from home." We spent a considerable sum establishing a large workshop. Unfortunately, less than a year on she has reneged and left.
We can hold her to the commitment, but collecting rent would be problematic. We can only look for another tenant and write off anything spent on the workshop as a bad experience. Fortunately, tenant two is a different story and a pleasure to deal with.
Not complaining, just outlining what can happen from a landlord's perspective.
A: As a practical matter, it's probably harder to force a tenant to stick to a long-term lease than a landlord. I suppose that helps to reduce the imbalance between landlords' and tenants' powers we've been discussing in this column lately. Still, it must have been really annoying for you.
But maybe all is not lost. Maybe you can find a new tenant who would also love to have a workshop.
- Mary Holm, ONZM, is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.
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