Why Asset Class Investing

The final of a three part series

When it comes to achieving one’s lifetime and lifestyle goals, how effectively you have managed money and how effectively you have invested are critically important strategies.  Two of the three fundamental strategies to lifetime financial security – the third being risk management.  It stands to reason then that understanding where and how to invest is going to necessitate some important decisions and actions.  94% of investment performance is determined by the asset class you choose to put your money in – whether using KiwiSaver or any other lump sum retirement fund.  There are only four major asset classes.  Shares, Property, Bonds and Cash.  The more you put in Shares and Property – the higher the return.  The more you put in Bonds and Cash – the lower the return.  Other factors now influence your returns.  Namely fees and tax.

Looking at the index returns in part two of this series highlights asset class performance.  The funds management industry both in NZ and around the world has attempted to sell their particular version of products (managed funds, unit trusts, KiwiSaver, personal super) as an ‘outperformance’ of one or all indexes – or a combination of same.  Outperformance being ‘alpha’.  By stock picking, market timing, hedging, short selling and any number of manual interventions ‘active’ fund managers are attempting to ‘beat the market’.  The problem is it comes at a cost.  Fees are higher for active funds management than for passive funds management – that’s fine if value is added.  None of us (well most of us) don’t complain if we get value for money with a service or product.  Unfortunately active fund managers seldom outperform, especially over the long term.  When adviser fees and custodial fees are then deducted (additional to management fees) and tax is paid to IRD your net return is often a disappointing reflection of hoped for gross returns.

Ongoing asset class investment then is simply buying the index (of whatever asset class) and letting the market take you on its ride of volatility.  Shares and Property being more volatile than Bonds and Cash.  You will achieve gross returns relative to your chosen assets or a blend of same – manual intervention is minimised.  Seems straightforward – but I’m afraid it’s not.  There have been 13 market recessions since the second world war.  The biggest in living memory being the most recent, the Global Financial Crisis.

When markets decline – people panic.  They fear loss.  That fear is exacerbated by media and market commentators selling news.  Bad news sells better than good news.  So investors either look for perceived safety, security or alternatives and get dealt to by a combination of naivety and product spruiking or conservatism.  Examples of this are syndicated property, condominiums and apartments (NZ and offshore) finance company debentures, residential investment property, hedge funds, term deposits.  So when investing in managed funds you combine market volatility with tax and fees – ‘the deal’ becomes surprising and often disappointing – you go looking for ‘a better deal’ or opt out and crystallise loss.

KiwiSaver investors are a good (new investor) example.  Many will be confused in time as they are intimidated or wooed by bank personnel focused to either short term performance or ‘simplicity’ of management (keeping everything under the one roof) or a promise of lower fees, without explanation as to how or why.

The critical decisions – like all long term investing:

1. What asset class are you in
2. How is volatility and therefore risk being managed (diversification)
3. What are the tax implications.  Getting your PIR wrong could cost you your total accumulated sum in back tax and penalties
4. What are the fees – over the long term and what is the rationale for charging them.

Your bank cannot and will not proffer this advice – ‘class’ advice by law prevents them from doing so.  Asset class returns don’t move in harmony and will ebb and flow in reaction to short-term factors.  But over the long-term, there are similar return expectations.  So having a range of drivers in your KiwiSaver portfolio can help you achieve strong performance but with lower volatility.  That’s the free lunch.

We favour passive funds both for KiwiSaver and lump sum investors – it’s called asset class investing.  The objective being the achievement of our clients’ investment goals through:

• minimising costs (passive vs. active management)
• minimising volatility (risk) (diversifying and engineering)
• providing index related returns (passive funds – index related)
• management of our clients (doing ‘life boat’ drills- preparing investors for the inevitable next ‘Bear’ market).

There have been 13 Bear markets (20%+ market declines) since WWII.  When you understand your investment philosophy and you have an overall strategic plan the media and the ‘talking heads’ of funds management can be ignored.  That’s not to say that watching your investment freefall in value each time the market makes a correction is easy to stomach.  Index funds are not ‘performance’ oriented – they simply reflect market conditions and market cycles – they have adjusted many times before and will do so again and again because that’s the nature of capitalism.

Measuring historical evidence (market indices in all asset classes) allows you the only factual basis of comparison (mean reversion).  No economist, financial adviser or fund manager can promise ‘out performance’ with conviction – there is no such thing.  What you need is a plan with strategies to achieve your goals.  That, we can manage and measure.

The information provided in this blog is not intended to be a substitute for professional advice. You may seek appropriate personalised financial advice from a qualified professional to suit your individual circumstances.