NZ T R E N D S Independent KiwiSaver research and analysis Page 1 of 6 January 212 Long- term Returns and Considerations for KiwiSaver Members At the beginning of every year it is customary to review investment returns for the previous calendar year. Asset class returns for were low but probably not nearly as bad as the weak global economic backdrop suggested. The New Zealand real cash return was negative as rising inflation overcame stable money market rates. Local and international bonds were the standout performers with the New Zealand 5- year Government bond yield declining 15 basis points - leading to sharp capital gains. For the year KiwiSaver funds (on average) in the multi- sector categories produced the following returns. Average Return for I.R.D. Default 4.1% Low Equity (Conservative) 3.6 Medium Equity (Balanced).5 High Equity (Growth) (3.) But rather than focus on the returns for the calendar year, these results can be used to update longer term returns. Longer term returns, updated to the end of, are the focus of the first NZ report for the year. Nominal and real returns produced on the main asset classes and multi- sector portfolios over 2 years to the end of are emphasised and Figure 1 shows the cumulative growth on $1. This analysis is based on gross annual returns for the recognised indexes. The results are highly unusual in that International Bonds on a currency hedged basis is the leading performer. The returns on International Shares (unhedged) suffered from the impact of 2 major crises - the recent global financial crisis and the unwinding of the technology bubble in the early 2 s. These results highlight a phenomenal period for relative t. These results can be misconstrued as representing the new normal and that shares are not required for long- term capital accumulation. But deviating from a tried and tested investment principles, such as shares for long- term growth, is a dangerous game. In Figures 2 the dollar- based growth is converted into nominal and real returns. 7 6 5 4 3 2 1 Figure 1 Growth on $1 from to NZ Property (listed) Int. Shares (unh) Int. Bonds (h) NZ Inflation 21 28 26 24 23 22 21 2 1998 1996 1994 1992 International Shares (unhedged) and NZ Listed Property produced pedestrian returns. These returns are not only below expectations but below cash. The result for NZ Listed Property is hampered by an awful negative return at the start of the period. International Shares (unhedged) have struggled through the aforementioned crises and are actually at the same inflation- adjusted performance level as 1 years ago. According to the Credit Suisse Annual Returns Yearbook, the very long- term equity risk- premium the excess return over the risk- free investment - on is 4.1% per annum. This excellent report also records real returns on NZ bonds and NZ cash as 2.% and 1.7% respectively. 595 495 435 356 229 228 161
Page 2 of 6 Int. Bonds (h) Int. Shares (unh) Figure 2 Real and Nominal Returns (- ) Real Return Nominal Return NZ Property (listed) 1.8 1.8 4.2 4.1 4.2 5.2 5.9 6.6 6.9 7.6 8.3 9.3 Figure 3 Volatility of Annual Returns ( ) Int. Shares (unh) NZ Property (listed) Int. Bonds (h) 5.2 14.9 17.7 17. 2 4 6 8 1 Return (%) p.a. Over the past 2 years, real returns obtained on and has been significantly higher than the historical average. For those new to retirement savings (most KiwiSaver members) they only experienced healthy returns on income assets and possibly expect anything different in the future while the opposite could be true for expectations. While NZ Cash has posted two consecutive years of negative real returns, NZ Government Bonds continue to produce well above average returns (real return 8.7% in ). Let s bring volatility into the equation. Figure 3 shows the volatility of annual returns over the period. The order of the asset classes is very much in line with theory and typical investor expectations: Shares have been more volatile than property, which in turn has been more volatile than bonds, with cash the least volatile. Interestingly enough, despite recent investment articles highlighting the high volatility of markets, recent annual volatilities have been lower than the very long- term averages. Placing the volatility and return figures into a risk- return scatter plot the abnormal trend, of low volatility income assets outperforming high volatility riskier assets, is obvious (see Figure 4). Can this continue and for how long? One must remember that local short- term interest rates were artificially high for many years as NZ needed to attract foreign inflows to offset poor internal savings. This anomaly has hopefully self- corrected and improved internal savings reduction. Return (%) p.a. 1.9 4.9 5 1 15 2 Annualised Standard Deviation (%) Figure 4 Risk (volatility)- Return Scatter Plot (- ) 1 9 8 7 6 5 4 3 Int. Bonds (h) NZ Property (listed) Int. Shares (unh) 5 1 15 2 Volatility (%) p.a. Why have investors not been rewarded for the additional risk associated with growth assets over such a long period? Could the recent breakdown in the risk- reward relationship be one of the reasons why so many KiwiSaver investors have selected conservative investments? If you do not expect to be rewarded for holding risky assets it makes sense to invest conservatively. Only the older KiwiSaver members would have experienced a sustained period of equity return superiority. Due to the news frenzy, are swamped with any negative economic release and the occasional company scandal. Hourly - term investors and only serves to shorten time- frames.
Page 3 of 6 The risk inherent in the situation is on the upside. What this means is if the equity risk premium returns with a vengeance many investors will miss out on valuable growth. Currently the implied equity risk premium on the NZX5 Index is a fairly generous As we well know with investing, as soon as practitioners start to give up on a particular time- tested convention, such as building long- the chances of the benefits reappearing increase. Time and time again investors are tempted to deviate from well- devised long- term investment strategies and those that do tend to destroy value. Multi- asset portfolios Most KiwiSaver investors make use of multi- sector funds, so the analysis of multi- sector funds is vital to the research. Figure 5 shows 2 year growth on $1 dollars invested in hypothetical conservative, balanced and growth portfolios. In Figure 6 the numbers are converted into annualised returns (real and nominal) and volatility is also provided. Naturally, the same observations at an asset class level will flow through to the multi- sector analysis: defensive portfolios have produced higher returns with lower risk. The first four years of KiwiSaver have seen a continuation of the return trend favouring conservative assets but should strong equity returns recur, investors risk missing. In line with the warnings from behavioural finance, many investors will only seek- out higher investment risk profiles after high returns have being posted. While getting younger investors to be more growth- oriented is a big challenge a 4 year perspective can provide a historical viewpoint more in tune with investment theory and investment market history. 54 49 44 39 34 29 24 19 14 9 Figure 5 Growth on $1: Multi- sector portfolios (- ) Conservative Balanced Growth Inflation 21 23 46 39 337 161 Funds costs and taxes have not been taken into account but nonetheless one can get a sense of how low the all- in real net return to investors has been. Clearly obtaining positive real net returns is a challenge. However, this should be the objective of investors. Figure 6 Real and Nominal Returns (- ) If the recent 2- years return profile is maintained most KiwiSaver investors will be better off. Extending the 7.9 Balanced 4.6 analysis to a 4 year period, the next section, suggests 7. otherwise. It also shows how accumulating wealth is non- linear and that periods of weak returns are often 5.1 Conservative 5.5 subsidised by periods of excellent returns. While limiting 7.9 big losses is a vital part of investing success so is participating in high sharemarket returns. The opportunity 2 4 6 8 1 12 (%) per annum cost of being invested in cash when the sharemarket produces a sparkling return is called a - you never get the same opportunity to recoup. Over the past 4 years have produced gross annual returns in excess of 3% seven times yet none of those occurred in the last 2 years. Missing out on these bumper years can seriously hamper growth. Investors have not paid this penalty in recent years as such returns have not materialised. Growth Volatility Real Return Nominal Return 3.8 6.3 1.7
Page 4 of 6 4 year return analysis People may ask why a 4- year analysis is relevant but roperly used past returns can be extremely useful. In addition,, market returns revert to their long- term averages following periods of either very strong or weak returns. Sophisticated asset allocation models require long- term return averages as inputs. Understanding the underlying sources of historical returns, while beyond the scope of this report, is also valuable. This report will briefly cover local bonds. Over time the return on bonds is largely accounted for by the interest coupons that bonds generate. Hence past returns tell us every little about the return that Government bonds purchased now would earn during subsequent periods. The investor s starting yield to maturity is a better guide to future returns. Figure 7 shows the 5- year- Government bond yield (constant maturity) since 1985. Due to the higher yield environment a buy- and- hold investor at the start of the period (1985) would have achieved a much better return than a new investor in 22. Start Year Start 5- yr yield Future 1 Yr Return 1985 18.4% 13.% 22 5.9 7.3 212 3.4? This issue is discussed in more detail in the Appendix One can say with great conviction that the future 1- year return for new Government bond investors will be much lower. Despite that fact that bond markets are no longer dominated by Government issues the starting yield argument is still relevant. 25 Figure 7 5- Year NZ Government Bond Yield It is important to note that multi- sector fund allocations have changed over the years with the allocation to international assets steadily increasing. This makes a long- term analysis tricky as applying standard asset allocations retrospectively does not match actual investor experience. Nonetheless the principle of market cycles and returns oscillating around the long- term average remain true. The following graph shows the growth on a $1 dollars over the period and the growth converted into real and nominal returns per annum. Figure 8 Growth on $1 plus Real and Nominal Returns (1971- ) 1, 1, 1 23 21 1989 1987 1985 1983 1981 1979 1977 1975 1973 1971 2.4 3. 4.7 Real Return Inflation Nominal Return 9. 9.6 11.3 7,269 3,896 3,121 1,32 Yiled to Maturity (%) 2 15 1 5 Mar 85 Sep 86 Mar 88 Sep 89 Mar 91 Sep 92 Mar 94 Sep 95 Mar 97 Sep 98 Mar Sep 1 Mar 3 Sep 4 Mar 6 Sep 7 Mar 9 Sep 1 2 4 6 8 1 12 Return (%) p.a. From Figure 8 one can see that growth assets had a great run from 197 to 1986. Inflation was a major problem during those times and high NZ inflation meant negative real returns on bonds and cash. This persisted for a long time and was the only sector to preserve purchasing power. Things have changed materially since then with the subsequent period characterised by lower inflation. Although not rampant, inflation is starting to rise again in developed countries. There is every possibility that the future trend in inflation cycle is upward.
Page 5 of 6 What does this mean for KiwiSaver investors? Reports and research that can put investment returns into perspective and promote long- term investing should be beneficial. The financial media tend to promote short- termism because it is a lot more interesting than long- term investing (which in essence is boring). Regular attention to the financial news and the activity it spurs suites some businesses but is generally destructive for the investors involved. KiwiSaver investors must make every effort to ignore market noise and the short- term focus it promotes. A focus on long term results can help investors set a secure long- term path for their retirement savings via KiwiSaver. If the plan has been well devised the key is to stick to it. This approach will require occasional review and assessment but ideally very little or nothing will change on a yearly basis. With this in mind investment programs, such as lifecycle programs and target date funds (although not without their shortcomings) make a lot of sense. While most KiwiSaver members are invested in diversified, multi sector funds the overall conservatism seems unwarranted. On another level the extent to which some members are switching funds (within a scheme) is alarming. In the financial year almost 3, members switched between funds at least once 4 members switched 5 or more times during the year. Single- decision investment programs have the potential to prevent many of the pitfalls associated with investing but can be offset by the opposing need to change and tinker. Financial planners often feel the need to put down a proposal as opposed to the active decision of doing nothing. Target date funds, only available within KiwiSaver via the AonSaver KiwiSaver Scheme, continue to gain prominence in the Defined Contribution retirement savings market in the United States. These funds, that change asset allocations as the fund gets nearer to the target date, help by leaving the difficult asset allocation process in the hands of a professional investor within a single fund. Te life- and does not feel comfortable making investment decisions. A perennial issue is finding those elusive active fund managers who have the ability to generate superior returns. This search opens up another can of worms in that if too many investors recognise an alpha- generating fund manager soon enough the manager is running too much money and starts to underperform. In addition, superior fund managers know they are superior and charge accordingly, often via lucrative performance- based fees. Hence, it is a good initiative that the Financial Markets Authority (FMA) is reviewing KiwiSaver performance- based fees as a number of these arrangements seem one- sided in favour of the fund manager. All these issues combined reflect why retirement savings, essentially quite a simple task on paper, is immensely difficult in practice. This can explain why only the disciplined minority are enjoying a financially secure retirement. Investors must be perennially on the lookout for the pitfalls. This is where KiwiSaver providers and advisers can play a valuable role. While a number of providers have succeeded in converting overly conservative default members into more appropriate asset allocation profiles, the total number remains high. In broad terms there are two sets of members: younger members too conservative with their investment selections and appropriately invested members, who need to be aware of the pitfalls and behavioural failures that can derail a long- term plan. The necessary (but time- consuming task) of explaining the benefits of a more appropriate asset allocation to younger members and educating members, who seem properly invested, on the destructive impact of regular switching are two interventions that will take the KiwiSaver industry forward. Contact independent research, analysis and comment on the KiwiSaver industry. The newsletter is produced by Collin Nefdt, an independent KiwiSaver analyst. He can be contacted at nztrends@yahoo.co.nz
Page 6 of 6 Appendix Yields and Future 1- Year Returns In the section on 4- year asset class returns reference was made to the high correlation between the starting bond yield to maturity and prospective returns. Low starting yields are a significant headwind to future bond returns and based on the current 5- year Government yield, bonds have little chance of repeating the same level of returns seen in the past. Investors should scale down their bond return expectations. The next graph plots the historical yield to maturity with realised and forecast returns. This shows that investors should reasonably expect 1- years returns in the range of 5%- 6% going forward. Dramatic upward moves in interest rates could alter this scenario. If this were to occur it would actually be blessing as coupons will be reinvested at higher rates and improve prospective returns beyond a certain time horizon (normally 5 years). A simple regression analysis can demonstrate why this is necessary. The next graph plots the starting 5- year bond yield with the realised future 1- year return on the NZX Government Bond index the close fit is immediately apparent. 2 16 12 5 Yr Gov Bond Ytm Actual Future 1 yr Return (%p.a.) Forecast Future 1- yr Return Future 1 Year Return 15 1 5 Correlation.97 R 2.94 % 8 4 1985 1987 1989 21 23 5 1 15 2 5-year Gov Ytm @ 31 Dec The resulting regression equation can be used to forecast returns based on yield scenarios. The current 5- year bond yield to maturity is 3.4%, which implies a future 1- year return of 5.6% per annum. This is significantly below the current rolling 1 year bond return of 7.3% per annum. This analysis is based purely on NZ Government bonds. Bond markets have developed tremendously and in the US, for example, mortgage and asset backed securities make up the largest segment of the bond market today. The New Zealand bond market is also more credit oriented these days. Notwithstanding the analysis still has great relevance.