How does a nest egg grow? Erratically

By MARY HOLM

Q: My basic question, following your column about the mother and school kid (Money Matters, November 10), is: How will the $6500 the mum is thinking of putting into Tower Corp's Tortis International Fund provide her with a nest egg at the end of 20 years? And how much is this likely to be at that time?

One reason for my question: Don't these funds pay out a dividend each year, so how does the $6500 grow in value? Or can the dividend be re-invested in the same fund to compound to the end of the 20 years?

Second reason for my question: I will have $10,000 available at the end of next year and am wondering what I should do with it.

Should I put it in a bank investment account at 6 or 7 per cent and compound the interest, so that at the end of 10 years (I am 56) it will have become either $17,000 or doubled?

Or should I put it into something like the Tortis International Fund? What would it be at the end of 10 years?

A: Let's start with your question about dividends.

Tortis International holds shares in the world's biggest companies and most of them pay dividends.

But the fund managers reinvest those dividends in the fund, rather than paying the money out to investors. That means that, as dividends flow in, the value of units in the fund rises.

Most other managed funds that hold international shares either do the same or give you the option of reinvesting your dividends or receiving them in cash. I strongly recommend reinvestment.

But dividends aren't the only source of growth - or even the main source - for many share funds. The value of investments in the fund also grows as share prices rise. Of course, those rises don't always happen.

In some periods, the total value of the shares held by Tower Tortis International, or practically any international share fund, will fall. This happened in the past 18 months or so.

In other periods, the share value will grow steadily. Sometimes it will grow fast - as in the late 1990s.

Usually, over periods of five years or more, there'll be more rises than falls, and anyone investing in an international share fund will come out with more than they put in, sometimes much more.

This is even more likely over 10 years. People who invest for a decade almost never lose money. And over 20 years you can be practically certain to gain.

At least that's what history tells us. There can be no guarantees of the future.

On your question about the mother's $6500 - no, it won't provide a nest egg, if you think of that as being enough for a comfortable retirement. But it all helps. And hopefully the mum will be able to add more to it over the years.

So how much will $6500 grow to in the Tower Tortis International Fund over 20 years?

Because we can't foretell what will happen to dividends or share prices, nobody knows.

But to give you a rough idea of what might happen, let's assume that over the years she gets an average real (inflation-adjusted) return of 5 per cent, after fees and taxes. That's about the level experts use for share fund forecasts.

Under those assumptions, the $6500 would grow to almost $17,250. Note that, because we've adjusted for inflation, that money would buy in 2021 whatever $17,250 buys today.

What about your situation? The news isn't all that rosy, I'm afraid. Under the same assumptions, over 10 years your $10,000 would grow to almost $16,300 - again in terms of today's purchasing power.

That's disappointing, compared with what you're hoping to get in bank term deposits.

But interest rates have fallen a long way since you looked. These days you would do well to get 5 per cent from a bank.

What's more, you haven't taken into account taxes, fees or inflation - which you should always do on any investment if you want to know how much will end up in your pocket.

There are no fees on term deposits. But after tax and adjustments for inflation, your real return, at current interest rates, would be around 1 or 2 per cent.

At 1.5 per cent, over 10 years your $10,000 would grow to only a bit over $11,600, in today's purchasing power.

It's important to note that all of these numbers are iffy. They assume that inflation, taxes, fees and interest rates won't change, and that returns on shares will continue much as they have in the past. They're only best guesses.

What we can say with certainty, though, is that if you go with an international share fund, there will be times when the value of your investment falls.

Would you panic if your $10,000 turned into $7000? If so, stick with the term deposits.

But if you feel you could ride through such a downturn, knowing that those who hang in long enough always end up gaining, go with an international share fund.

It's highly likely that, 10 years later, you'll be glad you did.

Q: I was just reading your response in last week's column to a writer regarding using Start or NZIJ to enter and exit Tower International or WiNZ funds.

I belong to a few Tower funds including Tortis International, and have paid no fees by contacting and paying Tower directly when joining the funds.

Can you advise why somebody would want to pay a third party like NZIJ or Start, when entry to the funds can be made direct?

A: You would want to pay Start, or other brokers or advisers who charge an entry fee, if you wanted advice on how much risk you should take, which investments would best suit you, and so on.

That's the deal. Generally, if you pay upfront fees you get advice.

But if you know what you want and don't need your hand held, you can certainly go directly to many fund managers. Often, they will charge you no entry fee.

There's no advantage, though, in going direct versus going via NZIJ, which also charges no entry fee.

True, NZIJ receives an annual trail fee from Tower of 0.25 per cent of your investment. There's no trail fee paid on investments made directly through Tower.

But these trail fees are not taken out of individual investors' accounts. They come out of the whole fund.

So it makes no difference to you whether there's a trail fee attached to your investment. You could argue, though, that the more people who go directly to Tower, the less the fund will pay out in total trail fees, and the better off all investors will be.

So good on you. All other investors in Tower funds should be grateful to you!

Q: I have understood you to have written many times that no one can predict what will happen to, for example, exchange and interest rates, property prices, the Singapore stock exchange, Japanese Government bonds, etc. Hence the wisdom of using indexed or passive share funds.

But recently you referred to active share funds, which "hire experts to make the investment decisions".

Since predictions are not possible, at what are these folk "experts" - besides relieving clients of money as their commission?

A: Good question! But perhaps you're being a bit too tough. For the sake of other readers, let's look at a bit of background.

The performance of an index fund, which holds the shares in a market index, closely follows the performance of the market sector covered by that index.

For instance, TeNZ, based on the NZSE10 index of this country's biggest 10 shares, performs about as well as the big-company end of the local market.

And MidNZ, based on an index of mid-sized New Zealand shares, performs about as well as the middle market.

(I say "about" because, although index funds are relatively cheap to run, some costs still come out of the funds' returns.)

Managers of active funds, on the other hand, set out to buy and sell shares cleverly enough to perform better than the sector of the market in which they're investing.

Basically, that means they've got to buy under-valued shares and sell over-valued ones.

Given that the collective wisdom of all the people in the market usually means shares are priced about right, that's quite a challenge.

I concede it's quite possible the local market is not all that efficient at pricing shares in small New Zealand companies that the big financial institutions don't bother with.

Even so, fund managers wanting to beat the market still have to work out which of the inaccurately priced shares are cheap, rather than dear.

In any year, of course, some managers perform better than the market. They'll say it's skill; others say it's often luck.

Over the years, we tend to see different active funds doing well in different years. But few fund managers consistently outperform the market - at least not as measured by unbiased experts, such as academics.

And there's no way of knowing, in advance, which ones will do unusually well. As I've said before, past performance is no guide to future performance.

There's more to it than performance, too. Active funds pay higher transaction costs than index funds, because they trade more often.

In New Zealand, too, active funds must pay tax on their capital gains, while index funds don't.

And active funds must cover the costs of their managers and their research - costs avoided by index funds.

By the time you take all of that into account, it's rare indeed for an active fund to outperform the market over more than a few years. Given that share funds are long-term investments, it makes sense to me to go with an index fund.

So where does all this leave your question?

First, I wouldn't say share predictions are not possible. People make them all the time, and I suppose fund managers are as good as anyone at doing it. So we could call them experts in that field.

Trouble is, it's such a difficult field that even the experts get it wrong often enough that I'm not about to put my money behind them.

* Send questions for Mary Holm to Money Matters, Business Herald, PO Box 32, Auckland; or e-mail: maryh@pl.net. Letters should not exceed 200 words. We won't publish your name, but please provide it and a (preferably daytime) phone number.