The World Cup of Investing

Jim Parker, Outside the Flags

It’s been a banner year for New Zealand sport, with a world championship win in women’s netball, the narrowest of world cup losses in men’s cricket and an upcoming attempt by the All Blacks to win an historic third consecutive rugby world cup.

It’s fair to say that just as NZ punches above its weight in global sport, its share market has been an outperformer in recent years. But it’s also worth keeping a sense of perspective, both in terms of history and the size of the opportunity.

In sport, the women’s netball team, the Silver Ferns, waited 16 years to win the world cup, and then defeated Australia by just a single goal. Even the All Blacks, historically the world’s best rugby team, took 24 years to repeat their 1987 world cup triumph.

NZ shares aren’t world beaters every year either. It’s true the Kiwi share market has been the developed world’s second-best performer in four of the past 10 years. In fact, it has posted positive annual returns for every year since the GFC.

But you only have to cast your mind back a little bit further to find years when the Kiwi market was a relative struggler. In 2000, it was the worst performing developed market in the world. In 2005 and 2006, it was the third worst, albeit with positive returns.

If you go back even further, the NZ market was hit harderthan most by the 1987 crash and its aftermath. The market, as measured by the S&P/NZX All Index fell by nearly 50% in 1987 and did not turn cumulatively positive till nearly a decade later.

Such was the pain generated by the 1987 crash in New Zealand that an entire generation of investors was turned off equities. The tragedy is that so many sought solace instead in poorly performing and illiquid property finance schemes.

There are a couple of lessons from all this for investors. Firstly, just as World Cup winners are hard to predict, there is no evidence that you can consistently outguess prices and pick which country will be the best market performer from year to year.

Patches.png

The table in Exhibit 1 ranks annual stock market performance in NZ dollar terms for 22 different global developed markets, from highest to lowest, over the past
20 years. Each country has its own colour (NZ is in black). Can you see a predictable pattern?

The conclusion is that if you can’t predict which country is going to perform best from year to year, it’s better to be broadly diversified across all of them. That way, you are more likely to capture the returns wherever they happen to occur.

The second lesson is you need to be mindful of how much your international portfolio is biased to your home market. Remember that NZ accounts for a tiny proportion of the global share market, at around 0.1% or one tenth of one per cent.

Of course, there are rational reasons for having a greater weight to your home market than its natural size in global terms might demand. These can include tax benefits, familiarity with local names, and the possible higher costs of investing abroad.

But in sticking close to home, you can also forfeit the benefits of global diversification, such as improving the reliability of outcomes and getting exposure to sectors either not available or only sparsely represented in your domestic market.

You can also end up with a handful of individual stocks representing a significant part of your portfolio, which exposes you much more to the idiosyncratic factors related to those companies than if you had been more diversified.

homebiasA2.png

Exhibit 2 shows the impact, as of June 2019, for New Zealand investors with 60% of their equity allocation in their home market. In this case, a single company, A2 Milk, represents 7.5% of the portfolio – or more than all the emerging markets (China, India, Russia, Korea etc.;) This one company has a greater weight in this home-biased portfolio than the United Kingdom and Japan together!

But it’s not just A2 Milk. Exhibit 3 shows that with a 60% home bias to New Zealand, just five stocks – A2 Milk, Auckland International Airport, Fisher & Paykel Healthcare, Spark, and Meridian Energy – would account for just under 30% of your portfolio. That’s more than for the entire US market or for all other countries outside NZ and the US.

homebiasA22.png

It isn’t just the stocks that you hold through a home bias; it’s also about what you’re missing out on. Exhibit 4 compares sector exposures with a 60% home bias (in blue) compared with a global weighting (in green). For instance, a home biased portfolio gives you just a~7% allocation to technology, compared to ~16% in the global portfolio.

In other words, a New Zealand investor with a strong home bias would have been underweight one of the global market’s top performing sectors in recent years.

Homebias222.png

Think of it this way: The All Blacks have nearly always fielded great teams, but they don’t win the World Cup every time. Other countries occasionally come to the fore, and by all accounts, the 2019 competition will be among the most evenly contested on record.

Likewise, while the NZ share market has been a strong performer in recent years, history shows there is no pattern to country-by-country returns and there will be years when the local market lags the rest.

NZ is a tiny market in international terms and while there are reasons for holding a greater weight in your home market than its natural weight, too much of a domestic bias can leave you with a highly concentrated portfolio.

We’ve seen that countries can go from top-of-the world to the bottom from year-to-year, so it makes sense to spread exposure. That way, you better positioned to capture the performance of global markets, where and when it occurs.

Being globally diversified also makes you less reliant on a handful of local stocks, with all the idiosyncratic risks they pose, and sets you up to capture the returns of other opportunities and sectors that you might not find at home.

At the end of the day, while there’s no World Cup for investing, this would be the best way to win it if there were.

Benchmarking - Birdie or Bogey?

We understand investment returns are uncertain and short-term returns vary widely. So how can we evaluate short-term performance?


Investment benchmarking is the best choice to track how well your portfolio is doing.

Birdie or Bogey?

Australian adviser David Haintz, founding director of Shadforth Financial Group and consultancy firm Global Adviser Alpha, often uses a golf analogy when discussing portfolio returns.

What sort of professional golfer couldn’t tell you whether they are getting birdies, pars or bogeys?”
— David Haintz; Australian Adviser

He raises an important point; most investors, when asked how their portfolio is doing, respond with "pretty well" based on a number at the bottom of a sheet. But is it a birdie, par or bogey?

David Haintz goes on to say:

"Portfolio benchmarking can answer the following questions: How has your portfolio performed?"

"What returns have you achieved? How concentrated is your portfolio? How much risk have you taken? Is this an efficient way of investing? Is there a better way?"

A Tale of Two Managers

Imagine we are comparing two fund managers. Maybe you have already invested with them or maybe you are considering doing so. How do we identify the superior manager? Surely the one with the higher returns? Do we need more information?

Consider the two managers below. Manager 2 has outperformed their peer by 5% over the past year.

Fund Manager Performance.PNG

Let's add one important piece of information. Manager 1 invests only in Australian shares while Manager 2 invests in NZ shares. A market benchmark for Australia is the ASX 300 Index (i.e. a good approximate for the whole share market). For NZ we can use the NZX 50 Portfolio Index.

Now we can compare each manager's performance to the market they participate in. Manager 1 has outperformed by more than 3% while Manager 2 has underperformed by about 2.5%. In other words, within their respective markets, Manager 1 added value while Manager 2 detracted value.

Manager vs Benchmark.PNG

Taking into account the markets which each manager targeted adds context. If we are looking only at the past year, Manager 1 is clearly superior; they scored a birdie, Manager 2 scored a bogey.

We produce quarterly benchmark reports which compare all of our approved funds to their benchmark indices. In doing so, we hope to add context and nuance to our understanding of investment returns.

Planning for Uncertainty

Continuing on the themes of uncertainty, we wanted to explore how we can still plan for the future with such a large range of possibilities. We will be boiling down all outcomes of the past 27 years into something we can use for investment planning.

A wide range of outcomes

Looking at all the 12 month outcomes from July 1991 to now

The tangled mess below shows every possible 12 month outcome, by quarter, over nearly 28 years for a globally diversified portfolio of shares. We can see the majority of outcomes are positive, with a few years of very strong performance and a few with very weak performance.

Ball of yarn 12 months Shares.PNG

Truly average outcomes

No smooth rides in any "average" year

The average outcome for all periods is a gain of 10.5%. The chart below compares an "average" period from January 2014 to December 2014 to the average of all outcomes. We see it is far from the smooth ride investors may wish for.

Average outcome 12 months shares.PNG

We can also consider an average outcome over 5 years, a gain of about 60%. The period from October 1993 to September 1998 starts with a year and a half of no returns, includes a one month drop of 13.5%, but ends nearly exactly in line with our expected average.

Average outcome 5 years shares.PNG

Creating realistic models

How we account for uncertainty when planning ahead

Let's revisit the ball of yarn chart from earlier, over five years and take useful information for our plans.

Ball of yarn 5 years Shares.PNG

Instead of considering every possible outcome, we can consider instead the probabilities. For example, let's add a line which 15% of outcomes fall beneath, and another which 15% of outcomes fall above. This gives a range covering 70% of outcomes surrounding the average. We have also included the "average" five years from above.

Average outcome 5 years shares with CI.PNG

Now we have a basic framework we can use in our plans. We can adjust the range between our boundaries to reflect the chance of success we believe is needed for our goals (maybe 25% instead of 15% for the bottom range). If the portfolio value falls below the bottom 15% range, we could increase contributions or reduce withdrawals to improve our expected outcome. If it rises above the top 15% range, we may consider taking on less risk in the future.

This is an simplified version of the Monte Carlo analysis we complete for our clients. A Monte Carlo analysis includes a few more statistical inputs and accounts for cash flows, inflation etc. However, the foundations remain the same and show how we account for uncertainty in returns to plan for the future.