NZ Herald 27 February 2021

AIf you’re saying that a fund might not hold the shares it says it holds, that’s highly unlikely. All New Zealand funds — KiwiSaver or not — are overseen by licensed supervisors. And both the fund managers and the supervisors are watched over by the Financial Markets Authority.

But I think your worry is that the shares in the funds might be over-valued.

We’re certainly not in Dutch tulip mania territory — as in the 1630s when, according to Wikipedia, single bulbs sold for more than ten times a skilled artisan’s annual income. Extraordinary.

However, it’s true that whenever the share markets zoom upwards — as they have in the last few months, despite a recent dip — there is a risk that shares are over-valued. In the end there is always a “correction”. But — in the longer end — the markets always recover.

Let’s look at the alternatives. Bank term deposits and lower-risk funds are bringing in low returns. And property is perhaps as over-valued as shares.

As long as you don’t plan to spend the money within, say, ten years, I think it’s best to leave it in funds that hold shares. That’s where my long-term savings are.

Don’t try to work out when it’s best to get in and out of shares. That’s usually a losing strategy, and much more worrying. For an example of what can happen if you drop out for a while, read on.

AFirstly, for the sake of other readers, exchange traded funds (ETFs) and index funds are known as passive funds, because their managers simply buy all the shares in a market index. They don’t trade shares unless the index changes.

Meanwhile, active funds’ managers select and trade shares they think will perform well.

Passive funds have been around for decades — and I’ve been recommending them for almost that long. But they have become much more popular, especially in the US, in recent years.

Your article quotes Michael Burry, who “shot to fame by betting against mortgage securities before the 2008 crisis. Burry was depicted in Michael Lewis’ book “The Big Short” and the subsequent Oscar-winning movie of the same name.”

The key points of the article are:

• “Passive investments are inflating stock and bond prices in a similar way that collateralized debt obligations did for subprime mortgages more than 10 years ago, Burry told Bloomberg News.
• “‘Like most bubbles, the longer it goes on, the worse the crash will be,’ said Burry.”

I asked Dean Anderson, founder and CEO of Kernel Wealth and a big fan of passive investing, for comment.

“First, let’s make clear that index funds and ETFs are nothing like a collateralized debt obligation (CDO),” he says, “CDOs are a type of derivative, with their value coming from the value of other assets. In the case Michael Burry is referencing, it’s sub-prime mortgages.” These turned out to be terrible investments in the global financial crisis.

“Meanwhile, the vast majority of index funds and ETFs track broad equity market indexes, holding shares directly in multiple companies across a range of sectors. Most of these companies will be successful and provide long-term growth to investors. This will offset any single company failure that occurs from time to time.”

Index funds have not caused bubbles, he says.

“One thing Michael, and many active managers, seem to get confused about is asset ownership versus trading.” Index funds typically trade about 7 to 8 per cent of the value of the fund each year, compared with “often over 100 per cent in actively managed funds. This is important, because it is the last traded share that sets the value of the entire company.”

“So, while index funds may own 30–40 per cent of the US equity market (about 5 per cent globally), they account for an estimated 10 per cent of trading volume, so the impact on company values is negligible.”

He adds that “there are hundreds of index funds, tracking a range of indices — at any point in time some may be buying shares in a company and others selling.”

“Does this mean parts of the market aren’t in a bubble? No. By its very definition, we can’t see a bubble till it has burst!”

Low interest rates have pushed term deposit holders into other investments, including shares. And higher demand — from direct investors and those in both active and passive funds — has pushed up prices. But it “isn’t an active versus index story”.

Anderson adds that a low-fee, well diversified index fund “seems like the best pick for my money right now. That way I am not concerned if one company goes bust, if a part of the market is a bit expensive, or relying on an active manager to try and forecast a bubble, ultimately to once again mis-time the market and underperform.

“Stay invested, regularly contribute and you maximise your chances of long-term financial success.”

Sounds a bit like what I said above!

Footnote 1: On mis-timing markets, I suspect you didn’t notice the Burry article was written in September 2019.

In the one and a half years since then, ETFS, index funds and most other share funds have gone through a huge Covid-related downturn but then an extraordinarily quick recovery.

The result: the MSCI world share index is now 27 per cent higher than in mid-September 2019. And the New Zealand share market is 13 per cent higher.

If you had bailed out of a share fund after reading the article, imagine how you would feel now.

Footnote 2: History is full of people like Michael Burry, who get their market timing famously right. Next time they are usually badly wrong.

ASome are. The lowest-risk funds in Sorted’s KiwiSaver Fund Finder — called defensive funds — include:

• Cash funds, whose investments are mainly bank term deposits or similar. And you’re right, their returns have tended to fall — although not always. See “show yearly returns” in the details about each fund.
• Funds with “bonds”, “income”, “fixed interest” or similar in their names. If you look at their holdings, you’ll see more bonds than cash. The returns on these funds are a bit more volatile, but higher on average.

Despite what the next correspondent says, higher risk and higher return go together.

AI’m sticking with the mantra. I’ve been watching for decades now, and I’ve never seen an investment with a high return that wasn’t risky.

But let’s say you’ve discovered the holy grail — a low-risk, high-return investment. Surely many of the people who follow investments for a living will also learn about it. They will rush to invest, and as demand soars, so do prices. Sellers of in-demand shares are not idiots!

Higher prices reduce returns. The dividends investors receive are a lower percentage of what they paid. And their capital gain will be smaller.

So you’ve got to get in at the start. And it would be a lucky person, indeed, who was the first to discover more than a few low-risk, high-return investments.

Turning to your shares, your current returns are, indeed, good. But I suspect that means your investments are riskier than you realise.

I remember a friend rather smugly telling me, years ago, how the dividends on his rock-solid share were much higher than bank interest rates. They had been that way for years during a relatively strong economic period. Suddenly, to his dismay, business conditions deteriorated and dividends were slashed. And of course the share price followed downwards.

Meanwhile, my short-term money in bank deposits maintained its returns.

By the way, you say a volatility index — which measures how much an investment rises and falls — is no predictor of the future. I disagree.

While we can’t predict when, say, a share fund will rise or fall, we can tell from the past the likely range of its rises and falls.

AAs a practical matter, it’s probably harder to force a tenant to stick to a long-term lease than a landlord.

I suppose that helps to reduce the imbalance between landlords’ and tenants’ powers we’ve been discussing in this column lately. Still, it must have been really annoying for you.

But maybe all is not lost. Maybe you can find a new tenant who would also love to have a workshop.