Wary investors seek lower-risk options

New Zealand investors need offshore investments to diversify risk, but they also want attractive returns without the volatility.

No investment decision is ever simple for New Zealanders, but at least domestic equities or other instruments have the virtue of being a known quantity. They are familiar and the risks are relatively well understood, although the returns can be volatile.

New Zealand's economy is more prone to one-off shocks than larger, more diversified economies, because of its heavy reliance on the agriculture sector and a history of natural geological events.

It makes good sense to invest elsewhere as well. Diversifying your exposure by investing offshore is a well-trodden path but, given today's conditions, how do you safely invest in global markets?

Recent history suggests you do so with a fair degree of caution.

When the dot.com crisis hit - I'm talking about the 2000 technology stock bubble, not the Megaupload founder - it wiped 57 per cent off the value of global shares. The decline in the value of international equity between September 2007 and March 2009 was 34.4 per cent.

I've seen plenty of crises hit global markets: the savings and loans scandal of 1991; the bond market rout of 1994; the 1997 Asian financial crisis; and the Russian debt default in 1998.

All these events caused global market volatility. Conventional wisdom suggests you recoup these declines in value in the ensuing upturn and generally investors do if they have the patience.

But the interesting thing about the global financial crisis and dot.com losses is that they have yet to be recovered. In fact, if a New Zealander invested $1000 in global equities in October 2000, today he or she would hold assets worth only $589.

So the conventional buy and hold strategy is flawed in the real-world timeframes of most investors. Traditional investment strategies are underpinned by an almost religious faith in the ability of the market to deliver returns over a period of time. However, investors' experience of the past decade shows that such faith can be bad for their financial health, as it has been in earlier periods, such as the 1930s and 1970s.

To be fair, that $1000 investment in global equities will almost certainly deliver a return eventually. When? Who knows, but the payoff will take several years and, I would argue, it is too long a wait.

An associated problem with traditional investment strategies is the manager's goal is to beat the market. When the market declines 20 per cent and the manager is down only 18 per cent, for example, the manager is beating the market. The investor, alas, is left with an 18 per cent loss.

The manager acts in this fashion because of their mandate, their definition of risk.

For the manager, the prime risk is underperforming compared with the markets.

So the zero-risk position is to be fully invested according to market weightings. As we've seen, this approach frequently leads to an erosion of investors' wealth.

All of this presents a dilemma to the New Zealand investor, who, common sense suggests, should have some offshore exposure to offset their domestic investments.

Thankfully, there is a way to generate attractive returns and avoid the volatility.

I believe investor appetite has fundamentally changed, but first, let me explain another, long-term approach to investing which is better aligned with investors' needs.

Absolute-return investing is built on a philosophy that is not constrained by a market index and uses a full toolkit to manage risk - cash, shorting, futures, pair trades and so on - whereas traditional equity funds are typically "long only" and cash.

An absolute-return manager is typically benchmarked against the risk-free rate (cash), not the market - an important distinction.

The aim is to generate higher returns than the risk-free rate every year and irrespective of market conditions.

It's important to note that each and every absolute-return fund manager we deal with has their own personal money invested alongside clients' funds.

What this means is that while an absolute-return manager sometimes may not catch the full extent of a rising market, it does enable the preservation of capital in a falling market, which other funds don't do. As a consequence, the significant losses responsible for destroying investor wealth can be avoided.

The last decade has ushered in a new paradigm for investors, one where the preservation of capital and strong consistent returns is the focus.

Instead of the bare-knuckle ride chasing the next market high and bearing the consequences of a crash, investors are more interested in a safe, predictable and profitable journey.

It is a fundamental change in perspective and is warranted, given recent history and the years of market uncertainty ahead.

If it sounds pragmatic and conservative, because it is.

Greg Peacock is head of research at New Zealand Asset Management, a global investment management firm specialising in absolute-return investing.

Sunday Star Times