DIY and forget the manager

By BRENT SHEATHER

Now the investing public's love affair with international shares is on the rocks, and the appetite for risk sharply reduced, advisers and fund managers are beginning to give their fixed-interest products more prominence.

Investing in a particular field or buying a specific investment product when it is the flavour of the month is not usually all that smart, but fixed-interest investments such as Government stock, bank deposits and so on should be a core component of most savings portfolios.

However, anyone contemplating fixed-interest investment is faced with a multitude of choices: direct investment in short-term bank deposits, bonds issued by state-owned enterprises, Government stock, convertible notes and capital notes are some of them.

Then there is the option of investing indirectly, via a multitude of local and overseas managed funds.

It is important to keep the right balance between risk and return.

For example, if your portfolio includes a large share component it might not be sensible to own a lot of high-risk bonds as well.

The opposite is also true: if you have no shares then having some lower-rated bonds - which promise higher returns - might make sense.

Then you have to decide whether to use a fund manager.

From a practical point of view, given the difficulty of assessing credit risk and the substantial benefits of diversification, it seems clear that if you opt for higher-risk, higher-return bonds, you should do it through a manager.

But despite the advertising and, it seems, the advice of much of the local financial planning community, the benefits of using a manager to put together an AA-rated fixed-interest portfolio are not at all clear.

At right we take a closer look at managed funds versus investing directly in low-risk bonds.

The road to enlightenment is winding and littered with dead ends and wrong turns.

Just assembling basic performance and cost data for the various funds is challenging, although excellent websites from ING, BNZ and BT make life a little easier.

Some funds detail their total fees, others publish a figure which is 50 per cent lower, under the guise that it is after tax, while others provide only the management fee.

Another key piece of information is the benchmark to compare the funds' performance with and what the benchmark's returns were.

In the United States, the regulatory authorities compel fund managers to provide a graph of their fund and the performance of the benchmark.

No such luck here, but if you're looking at New Zealand bond funds, the index that local fixed interest managers use is the CSFB Government Stock Index.

That index shows the return on a sample of the largest and most liquid Government bonds across all maturities, short and long term.

Unfortunately, choosing a managed bond fund is not just a question of buying the fund with the largest historic return. That's because performance has as much to do with the riskiness of the bonds in the portfolio as with the manager's "skill"; all things being equal, higher-risk bonds should produce the highest returns.

Any investor who buys the best-performing fund could simply be buying the fund with the lowest average credit quality.

When choosing a managed fund that invests in bonds, most people will simply pick the fund with the highest historic return in the belief that the fund manager is a clever fellow.

What this means, if one is to believe the glossy marketing brochures, is that the prescient fund manager is able to forecast the direction of interest rates and position your portfolio accordingly - buying low and selling high, just as many people try to do on the sharemarket.

Unfortunately, countless long-term studies confirm that it is no easier to beat the fixed-interest market than it is to beat the sharemarket indices.

Indeed, fixed-interest managers' costs are far higher than their sharemarket counterparts - as a percentage of total returns - making it that much harder to beat the index, or "add value", as they say in the jargon.

In reality, to achieve a similar return to the benchmark index, after fees, the fund manager needs to invest in higher-risk, higher-return bonds.

Today, for example, while four-year Government bonds yield 6.6 per cent, Fletcher Building capital notes of the same maturity yield 7.6 per cent, reflecting the fact that the Government is less likely to default on its bonds than Fletcher is.

Because most retail investors usually don't delve too deeply into the nuts and bolts of their bond fund's portfolio, and as details of bond funds' holdings segmented by credit rating are generally not available, buying risky bonds is something of a free lunch for fund managers.

Providing, of course, that there are no more surprises like Skellerup and Fortex.

The table at right shows the performance of New Zealand bond funds from six leading fund managers, compared with the CSFB index.

The table shows that the average return of these New Zealand fixed-interest managers has been consistently below the return an investor would have got by using a "buy and hold" strategy (the CSFB index). That is true over one year, three years and five years.

On average, these funds have been unable to add value to a fixed-interest portfolio, after deducting their fees, even though in many cases they have invested in securities that are riskier than Government stock. This is surprising given the extent to which the fund managers load their funds with risky debt, and underlines the difficulty of beating the market.

Some experts believe that the single biggest factor differentiating various managed funds is the level of the annual management and administration fees.

The fund research company Morningstar in the United States recently published a review of the performance of 629 sharemarket funds over five years, ranking them according to their expense ratio in 1996.

In eight out of nine categories the least-expensive funds significantly outperformed the most expensive.

Direct investment in Government stock or state-owned enterprise bonds involves no annual fees, only a low initial commission and no exit commission.

In addition, the investor has a contract directly with the Government or state-owned enterprise, knows exactly what he or she owns and what the return to maturity will be.

While New Zealanders can't yet go out and buy a bond index fund (fingers crossed though), you can buy three or four bonds of varying maturities which represent a rough approximation of the index.

Doing that will cost roughly $30,000 to $40,000, since the organisations that sell Government stock - sharebrokers, investment advisers and others - typically require you to buy in parcels of at least $10,000.

You can expect to earn yields of about 5.5 per cent for short-term Government stock, through to about 6.8 per cent for longer-term investments.

Those returns are taxable.

Although the cost advantage of "do it yourself" looks compelling, the decision to manage your own fixed-interest portfolio should not be taken lightly as there are no shortage of ways to underperform bank deposit rates, as various holders of contributing mortgages and property bonds can confirm.

The answer is to keep a close eye on the riskiness of your fixed-interest investments, and understand that if you want a better return than Government stock offers, the only way to get it is by accepting more risk.

* Brent Sheather is a Whakatane sharebroker and investment adviser.