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BCF guardians navigate eel traps

By Michael Coote

Friday 4th April 2003

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The lofty purview of the guardians of the Big Cullen Fund (BCF) is not picturesque.

There is the grisly spectacle of the Government Superannuation Fund's administrators thrown to ravening beasts by the Green Party for losing money on international equities. Higher GSF investment in New Zealand shares has resulted.

Michael Cullen's fond hope the BCF would somehow rise above politics is negated by the political hot potato of asset allocation. The three-year bear market in global equities has caught up with the local sharemarket as the economy goes into a cyclical downleg.

Diversification across economies is intended to smooth out differences in cycles.

It is likely the US sharemarket will lead the eventual rebound while New Zealand will lag. This will counter lobbyists who have promoted the superior performance of New Zealand equities over 2000-02.

The NZSE has been doing the dance of Salome before the guardians to lay its hands on up to 30% of the BCF's mainly borrowed largesse. The idea is absurd, notwithstanding the NZSE's commercially motivated creation of the NZSE50 blue-skies index.

The NZSE50 looks suspiciously as if it's made for vacuuming up BCF dollars and confirming in the eyes of the public the wisdom of the fund's investment in local equities.

Intriguingly, Inland Revenue reports no stampede from fund managers for binding rulings on passive NZSE50 tracker funds.

The NZSE has focused part of its sales pitch on the technical feasibility of the BCF buying hugely into the local sharemarket but has been oddly reticent about how the fund, potentially the country's largest shareholder, would eventually sell out.

The BCF can get in, we are told, but can it get out? Eel traps have characteristics similar to what the NZSE is proposing.

New Zealand's equity market makes up 0.2% of the global Morgan Stanley capital index. It doesn't make sense to fling 30% of a $2 billion annual tax-and-debt impost at a blip on the statistical radar screen.

If the BCF invested in passive international equities based on MSCI weightings, the New Zealand sharemarket would be a sparrow getting the odd crumb.

Sharemarkets return profits that reflect growth rates in underlying GDP. In essence, a sharemarket should return GDP growth plus inflation plus the equity risk premium above government bonds.

If we take optimistic measures, assume GDP grows at an annual average of 4%. Take a mid-point inflation rate of 1.5%. Add on an equity risk premium of 3%. That is an expected rate of return of 8.5%, close to the rather surprising 9% the BCF is supposed to achieve.

Annual growth of 4% would help justify BCF investment in NZSE listings, given the long-term optimal annual growth for the US is 3-3.5%.

At least two of the above assumptions are probably wrong. The government has retreated from its previous aim of 4% economic growth.

This is of great significance for the BCF. NZIER calculated 2.5% as the true average long-term growth rate but that was before the realisation of structural energy shortages. That reduces the return to 7%.

Therein lies the contradiction of the BCF with the government's ideology. The left hand does not know what the right is doing in championing Muldoonism with market characteristics. If the BCF is really a top-shelf government delivery of service that is going to invest heavily in New Zealand equities, then every stop should be pulled out to ensure 4% growth. But Helen Clark told Knowledge Wave II that was a right-wing conspiracy.

Equity risk premium is also problematic. Quoting research done a year ago by Robert Arnott and Peter Bernstein, the Economist (Mar 22) argues the estimated effective equity risk premium is as low as 2.4% and the past 75 years of sharemarket returns have been overstated because of "accidents of history, survivor bias, changes in corporate culture and many other factors."

Down we go to 6.4% on propping up NZSE listings before tax and fees.

Of course, the Reserve Bank could help out with a bit of inflation. To get back to 8.5%, we would need an inflation rate of 3.6%. However, higher nominal returns driven by inflation would merely mask lower real returns.

If inflation remains low worldwide, and 2.4%-odd is what to expect from the equity risk premium, then the BCF will need to invest in higher growth economies.

Some believe everything can be fixed under social democracy. Even the numbers. But wise heads among the guardians will not rest easy if they are being asked to subsidise a small economy with a larger amount of money than resale opportunities, market capitalisation and weak GDP growth.

The critical number is average GDP growth.

As the Economist observes: "Messrs Arnott and Bernstein recommend that investors accustom themselves to much lower [sharemarket] returns than they have enjoyed in the past. 'It's naïve to expect earnings and dividends to grow faster than the economy,' says Mr Arnott. That translates roughly into higher [pension] contributions, a longer working life and less rosy sentiment all round."

Which dovetails in with warnings that many New Zealanders believe they do not need to increase savings and investment because Dr Cullen has fixed their retirement income problem. They need to think again and, like the BCF, will have no choice but to place more funds overseas.

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