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Short-term losses boost risk

By Peter V O'Brien

Friday 7th February 2003

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The past year or three showed people should be choosy when selecting managed funds for their personal savings and potential retirement income.

FundSource Research's managed fund performance tables published each month in The National Business Review show substantial variations in returns over the past three years, depending on the asset investment specialisation in addition to the management skills of particular overseers.

The FundSource tables (pages 42-43) cover more than 500 types of unit trusts, group investment funds and superannuation funds. There are far fewer management companies. Most of the business is under control of banks, insurance companies and specialist fund managers.

FundSource's performance ratings are given stars, ranging from five to one. A five-star rating applies to the top achieving 15% of funds, the next 20% get four stars, the following 30% and the subsequent 20% two. The bottom 15% rate one.

The research company's note to the tables says ratings are calculated from risk-adjustment fund returns over the past three years, comparing similar type funds across all legal fund types.

It would be interesting to see a similar calculation based on one-year returns, although a 12-month period is no guide to the merits of a managed fund operating on a long-haul basis. Nor are historic returns any guide to future performance. Management companies remain the same corporate entities but personnel change.

A fund management firm is only as good as the people in it at any time. They have to adjust the fund's positions after analysing economic outlooks, likely market performance of asset classes and the merits of investing in particular countries.

Asset class and country considerations are embedded in the thinking of many managers, as is a possible enslavement to benchmark indices and consequent adherence, with modest variations, to the benchmark's weighting.

All that is referred to as "risk avoidance" and/or "risk management." (Those matters will be considered further in the second part of this discussion in relation to overseas-based investment companies and trusts listed on the New Zealand Stock Exchange.)

A glance at recent returns from funds diversifying equity investment in particular into overseas holdings shows flaws in the managers' approach. Returns were good when calculated over long periods, but there were flaws in the theory when applied to the past three years, when worldwide equity markets had large falls.

The funds' "losses" (negative returns) were often unrealised, as in the case of the Government Superannuation Fund, a matter related to the managers' "mark to market" practices.

The practice accounts for a fund's value on the basis of market prices at balance date, irrespective of whether there were realised or unrealised price erosion. Conversely, unrealised gains are brought to account in value. The issue gets more complicated when some funds are subject to actuarial assessment.

There was press comment recently that about 10%, or $2 billion, was "removed" from retirement savings in 2002. Maybe, but some of the "losses" were unrealised and on a long-term basis should be related to the earlier gains, however unpalatable, to people seeking gains over many years.

A downturn of, say, 20% in three years in a fund's returns and value may come off an 80% gain in the previous seven years of a total 10.

Retirement savings (superannuation funds) are obviously long-term investments. Short-term approaches, particularly in what can be described as non-superannuation unit trusts and similar managed funds, cause the problem.

Favoured asset classes come and go. Property is now hot. Everyone with reasonable cash resources has been exhorted to invest in commercial and residential property, the latter for rental. Market demand is supposed to make rental residential property an attractive investment.

That view must be related to the city or town, site and condition. In Wellington, for example, many properties in the suburbs west, east and south of the railway station have been on the rental market for some time at relatively high rentals.

The city has many relatively wealthy Asian students who will soon want accommodation. Local students make do. That is fine but the day comes when people balk at high rents and go downmarket, however uncomfortable. Property prices can rise as well as fall, a phenomenon applicable to all investment.

The selection of a managed fund should be based on potential shifts in the desirability of any asset class.

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