Diversification key to reducing risk

By CAMERON WATSON*

Many New Zealanders invest in Australian shares. Some do so by selecting individual shares, some of which are household names like Woolworths, BHP, Telstra and Westpac Banking Corp, while others speculate on smaller mining companies, or more recently newly listed dotcoms.

Others prefer to use a diversified fund like the locally listed index fund Tortis Ozzy. This fund tracks the Australian 20 Leaders Index that comprises the 20 largest companies on the Australian market.

The Australian market offers a far broader range of investment options than New Zealand and it has, especially over the past two years, provided higher returns than its New Zealand counterpart.

However, for those Kiwis sending money across the Tasman, there are some hidden risks to be aware of.

The New Zealand and Australian economies have much in common. Both are exporters (to roughly the same parts of the world) reliant on primary and commodity produce. This economic similarity means financial markets in both countries are influenced by the same forces and as a consequence very often move in tandem.

The sharemarkets in each country are also strongly related. Even though New Zealand has fallen behind over the past two years, the overall movements over the long-term remain very similar.

The New Zealand market has a far stronger correlation to the Australian market than it does with other world markets. Over this period the New Zealand market has a 92 per cent correlation with the Australian market while having only a 70 per cent correlation with other world markets, as represented by the MSCI World Index.

Because of the close relationship between the two markets, New Zealand investors who are looking to invest in Australia to provide some diversification to their portfolio should think again. The goal of diversification is to combine a series of investments that have low levels of correlation, or are negatively correlated. Doing this reduces the volatility of a portfolio because as one investment may be in a slump another may be performing well.

By investing in only New Zealand and Australian shares there is a high chance that most of the time they will move in tandem, thus providing little diversification benefit. Given the lower correlation that New Zealand has with other global markets, a better diversification option is to combine your New Zealand shares with a portfolio of global shares. There are many suitable investment funds that enable New Zealanders to do this easily including the AMP WiNZ Index Fund or global investment trusts such as Anglo & Overseas, Foreign & Colonial and Fleming Overseas.

This raises a second question. If Australia cannot be considered a truly international investment, should it be regarded as an extension of our home market? This remains up for debate but many investment advisers already combine the New Zealand and Australian exposures for their clients. This approach makes a great deal of sense and is easily accomplished by blending a New Zealand share portfolio with an Australian fund such as Tortis Ozzy.

Those who do regard Australia as a "home" market should remain cautious when selecting individual shares. Even with the internet and other news sources it remains easier to obtain research and information and gain a familiarity with New Zealand companies than it is with Australian companies. When choosing Australian shares investors should ensure they have enough information to make a sound investment decision.

The Australian stock market is a very good place to invest, especially if it is regarded as an extension of our local market.

Given the inherent disadvantages that face New Zealanders attempting to pick stocks in Australia, it is prudent to use a diversified fund like Tortis Ozzy as a core holding to anchor your portfolio. This can then be complemented with some carefully selected shares.

* Cameron Watson is an analyst with Craig & Co.