How a financial adviser would rate Cullen fund

By Michael Coote

Friday 4th October 2002

Scepticism has been aroused within the managed funds industry over the aim of the Cullen fund to garner an average 9% annual return. If Michael Cullen had consulted a competent financial planner, he would have had a needs-based analysis applied to his savings objectives.

Questions concerning time-frame and target risk-adjusted rate of return would have been central along with those on tax, inflation, debt, currency hedging and dollar-cost averaging. That Dr Cullen wants a booming 9% perhaps reflecting a requirement to exceed initial borrowing costs on seed capital suggests he is not risk-averse compared with the usual expectation level for retirement savings.

Returns on an equity fund seeking 9% will most likely be highly volatile. According to researcher Fund Source, international shares which will make up most of Dr Cullen's asset allocation have a 27% risk of negative return in any one year, a 14% chance over three years, 8% over five years and 2% over 10 years.

Dr Cullen's long-suffering investment partner, Ms Taxpayer whose money it really is will need to take the distant view to cope with gyrations in fund value.

But Dr Cullen himself will no doubt have some anodyne reassurances to offer about how she can look forward to putting up her feet on the Gold Coast while drawing the state pension from New Zealand.

Taxation

If it is a New Zealand-domiciled superannuation fund, or an actively traded unit trust or group investment fund, it will be taxed at 33% of total returns on dividends and capital gains. If the fund is passive, Dr Cullen could apply to his employees at Inland Revenue for a binding ruling to pay 33% on dividends alone without tax on capital gains.

Tax-efficiency would recommend a foreign-domiciled equity fund but the proposed risk-free rate of return tax could apply in future, something Dr Cullen has heard unsettling rumours about.

As the fund grows to its target $100 billion, it will become a booming tax cow and Dr Cullen might be able to earn a handsome rebate for Ms Taxpayer from his prudent thrift, although he is not going to hand it back to her directly as then she would only go out and spend it frivolously, he thinks.

Far better to do a money-go-round via paternalistic redistribution and keep the size of the state booming at $2 in every five of GDP while chivvying lazybones Ms Taxpayer along to produce 4% annual economic growth less than half the fund's target return from out of the private sector. Given Dr Cullen sets tax rates anyway, no doubt there could be some room to manoeuvre on his fund's tax bills.

Inflation

This eats away at the value of savings. Nominal 9% risk-adjusted returns do not mean much if inflation guts them. Inflation-adjusted figures from Fund Source calculated for 10-year rolling periods indicate that for the modern portfolio theory asset classes, cash generates 0-3% a year in real terms, domestic and international fixed interest 1-3%, property securities 3-7% and shares, both domestic and international, 5-9%.

If we assume a midline inflation level of 2% over the life of the Cullen fund then a 7% real return is being sought, which is bang in the middle of Fund Source's real share return projections.

Dr Cullen has a friend who runs the Reserve Bank to keep inflation low to help his savings plan. But if Dr Cullen wants higher inflation to fluff up economic growth then he may have a conflict over what to ask his friend to do.

Debt

Dr Cullen wants to borrow to kick off his investment. While leverage increases returns on the upside, it increases losses on the downside.

Most advisers would tell clients to think carefully about repaying debts and future borrowing capacity contingent on that. Dr Cullen can tell Ms Taxpayer to get a second or third job to pay off what will be owed and can request his friend at the Reserve Bank to borrow more in her name anyway, no credit checks required. No worries there.

Currency

Hedging against currency fluctuations might be desirable, although over the long run Dr Cullen can probably forget that as unnecessary. Ms Taxpayer will need to be kept in the picture in case the kiwi turns adverse.

The kiwi's behaviour may itself be influenced by impact of fund supply and demand flows in and out of the country. In investment (outbound) years, the fund should depress the dollar while in liquidation (inbound) years it should inflate it.

Dollar-cost averaging

Because Dr Cullen and Ms Taxpayer are going to invest a fixed $2 billion a year, they will be dollar-cost averaging as they buy into the sharemarket, meaning their fixed sum will purchase more shares at lower prices than higher ones on average, bringing down average acquisition cost per share.

But the reverse applies when they sell out year by year, when they will get a lower average sale price. A lot of other retirees will be selling at the same time, which could reduce sales values achieved by everyone.

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