Brent Shearer: Watch out for extra risk bearing no extra returns

One of the most fundamental rules of investing is that as returns increase so does the riskiness of the investment.

However, as Cliff Asness showed us a few weeks ago, in the investment world all is not always as it seems: perversely high dividends imply high rates of future growth rather than low; investing in shares, even for the long term, doesn't guarantee success; and, contrary to the advertisements, when buying shares, timing is more important than time in.

Other rules of thumb are routinely turned upside down: in New Zealand some bonds are more risky than some shares and no one in New Orleans says "safe as houses" any more.

So, is the notion that taking high risks will generate higher returns - and vice versa, that low returns implies low risk - just another naive model that fails the reality test?

It must certainly look that way to some local investors. Taking extra risk doesn't appear to add extra returns for many of the higher-net-worth individuals with their savings entrusted to financial advisers investing in expensive managed funds via expensive master-fund structures.

Their performance reports frequently disclose unexciting returns in the 6 to 8 per cent range despite having heavy equity weightings in their portfolios.

Many investors appear to be getting the risk of shares with the returns of bonds.

The culprits are, of course, low dividends from international shares and high annual management fees, the latter of which can be anywhere between 2 and 4 per cent a year. Fees on this scale effectively eliminate the risk premium in all but rampant bull markets.

With international shares expected to return long-term, on even an optimistic scenario, about 8 per cent annually, the writing is clearly on the wall for the investment industry.

In fact, in the United States and Britain, a price war has broken out between major players Fidelity and Vanguard in the index-tracking, exchange-traded fund field (listed funds like TNZ in New Zealand) where annual fees have been cut to a very reasonable 0.1 per cent a year.

But this is old news. Maybe the real significance of high fees for mum and dad in Remuera is not lower returns; it is high-risk portfolios - higher risk than is appropriate for most retired investors and way out of line given the after-fee returns.

This high risk arises usually in two different ways: too many shares, or junk debt.

Financial advisers with a 3 per cent annual fee structure implicit in their investment plans face a dilemma. They can either put together a medium-risk portfolio, as with the asset allocation of the average pension fund and, after fees, generate the same sort of returns one can get from the bank - or else they can wind up the risk of the portfolio.

The latter scenario usually prevails. The two favourite strategies are stuffing portfolios with lots of shares or hedge funds and, instead of buying investment-grade bonds, go for the junk debt option of finance company debentures and CDOs.

Nowhere is the local financial planning industry's predilection for things risky more notable than in the fixed-interest sector. What else could explain the popularity of high-risk, illiquid, poorly researched finance-company debentures in New Zealand?

It's no surprise that this sort of junk rarely appears in most institutional debt portfolios. Professionals know that bonds stabilise portfolios at times of stress but that, at the first sign of trouble, junk bonds change their spots and fall in price just like shares.

But if you are a financial adviser with 6 per cent bank rates as your benchmark and a 3 per cent fee overhead, then 9 per cent bonds from XYZ Finance is a prayer answered.

Collateralised debt obligations, leveraged bond funds are the other local manifestation of a high fee structures side-effect. Virtually no local adviser understands them and anecdotal evidence shows few of their owners actually know they own them.

But this hasn't stopped millions of dollars of mum-and-dad savings flowing into these high-risk products normally frequented by the likes of hedge funds and the odd member of the Saudi Royal family.

* Brent Sheather is a Whakatane-based investment adviser.