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How to lay a (nest) egg

By Donal Curtin

Friday 28th April 2006

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Assuming the government's proposed workplace savings scheme, KiwiSaver, comes through the legislative process in much like its proposed form, from April 1, 2007, employees who opt in will be able to choose from a range of KiwiSaver-compliant investment schemes and products.

For many it will be the first time they have had to choose among competing financial products. How should they make that choice?

As it happens, my day job over the past six years has mostly been concerned with sorting the good from the bad among fund managers' offerings. Here's what I've learned.

First and foremost, look for value-add - no product deserves your money if (pre fees) it can't beat its benchmark. If, for example, a fund manager who invests in New Zealand shares can't match the NZ50 Performance Index, then it's actually worse than the proverbial blindfolded monkey and a dartboard: over time, at least the monkey's random picks will average out around the index. Funds that (pre fees) beat the benchmark show some sign of investment competence, but now you have to ask whether their outperformance pays for their fees: if the benchmark is up 10%, and the fund is up 10.5%, but fees are 1%, you get 9.5% in your hand - again worse than the monkey will do.

And don't imagine all products routinely beat their benchmarks. There are fixed interest funds, for example, that post fees work out substantially worse than if you'd bought government stock yourself, and there is a large number of 'balanced funds' (that hold a cross-section of different kinds of assets) that have performed worse than depositing your money in the bank. Always ask for post-fees performance against a suitable benchmark.

Second, look for fund managers whose incentives are aligned with yours, namely superior investment performance. Many fund managers can make a comfortable living clipping the ticket on barely adequate performance, since they will be taking a percentage of the gross value of the fund's assets as their management fee: for them, its about the volume of funds under management, not necessarily shoot-out-the-lights performance.

Most often, the managers you'll want are the ones who own the business themselves and put their own net worth in the funds they run. Often, they'll be paid on performance above a benchmark (rather than simply on dollars managed), which, again, is likely to spur them to do better for you, and for them. And don't begrudge them their performance pay: you'll only be paying large amounts if good profits have been made. However, don't give them carte blanche: there are greedy funds that have written themselves over-generous performance incentives. Other things being equal, pick the fund with lower fees, as over the long term, even small fee differences compound to large differences in money in your hand at the end.

These 'boutique' managers, as they're often called, also often tend to back their own ideas with little or no regard to conventional yardsticks, whereas other managers are more likely to make timid nudges. This might sound riskier, but successful investing is a contest between different teams' intellectual capital, and you want to be with the firm that benefits most from its good ideas.

Within both the boutiques and the corporate-owned products, you'll find the option of the 'absolute performance' funds. These funds have an investment style designed to avoid an investment loss. A more conventional manager usually aims to outperform an index, and considers it a good year's work if it's beaten its index by 5%, even if the index itself is down 20%, and investors have therefore lost 15%. Absolute performance managers aim to avoid losing money, for example by cashing up investments before a bear market gets seriously underway, or by 'shorting' markets that are falling in value ('shorts' profit when the price goes down). It's an attractive investment strategy, especially for new investors who don't want nasty surprises early on.

New Zealand investors have never paid much attention to this next piece of advice, but here it is: avoid fads. Come next April, if all your friends and relatives are putting their money into funds investing in Australian mining shares, the one thing you must not buy is a fund investing in Australian mining shares.

Finally, you've got to be comfortable with the degree of risk: if you can't stand the thought of, say, a 10% loss, stay with the options that very likely won't deliver one and avoid the ones that might. But do take into account you might be in the scheme for 20 or 30 years. That has two implications: you've got plenty of time to make back cyclical losses, and, over such long periods, shares are likely to produce the highest return.

You mightn't countenance shares over shorter periods, but if you wanted to turn your KiwiSaver nest-egg into something really substantial, think about an option that holds a decent slab of shares, and ideally a decent slab of overseas shares: since you're already heavily exposed to the New Zealand economy through your job and house, taking on even more New Zealand assets just increases your exposure to local ups and downs. Indeed, when you've got plenty of time, there's a lot to be said for an all-overseas equities product: all going well, it will both spread your risks and increase your return. For any investment, that's a good outcome.

economicsnz@xtra.co.nz

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