Investment Articles

Investment Performance of Niche Property Investments

Again, it is difficult to define the investment performance of the property sector as a whole within the context of this document, due to the wide variety of sub-sectors and regions which must be considered. In the UK for example, residential real estate has delivered markedly different performance for each Investor that has participated depending on their strategy (buy to let/distressed assets/development etc), and residential property as a whole has delivered a different performance to commercial property or student accommodation. The same can be said for every combination of sector, strategy and region, therefore the context of this document does not allow for a detailed analysis of the investment performance of the sector as a whole.

Residential – The UK market offers some interesting opportunities, as depressed prices combine with a lack of buyer financing to create a viable rental market that can deliver yields of between 4% and 8% after costs. In other more distressed markets, properties can be acquired with heavy discounts, and rental yields can reach as high as 15% to 20%, although in many cases the quality (and therefore ability to dispose of) such property assets can be questionable, and Investors in these markets might better take advantage of current market dynamics by acquiring properties to refurbish and resell very quickly, capturing the discount as a capital profit and eliminating the long-term liability. Emerging markets also offer opportunities to invest in residential property, and the upside capital growth potential is often attractive, although the location risk associated with acquiring and owning physical property in many countries can be significant. Again, the cash-flow dynamics of direct investments in real estate are often very different from those of securitized investments such as property funds.

Commercial- Office space, shopping centres and industrial space have long been the focus of large Institutional Investors seeking stable income and long-term growth prospects. In developed markets where infrastructure is well established, commercial property is viewed as a stable income investment with some growth potential, and in less developed markets potential for growth is higher but so too is the level of risk to capital in terms of location and counterparty risk. The investment performance of commercial property varies from region to region, and across the varying sub-sectors such as office or industrial. One good point of reference for the global performance of commercial property investments is the FTSE UK Commercial Property Indices series encompassing the Retail, Office and industrial Indices; the All Property Index delivered 1.88% in the 12 months to March 2012.

Student accommodation – This is a growing sector, driven by demand for reasonable accommodation from University students; as the global population grows, so too will the volume of students attending University who will in turn require suitable accommodation in close proximity to their campus. Investors can purchase units in student blocks, effectively becoming the landlord of the unit themselves, or more often than not entering into an agreement with a management company who will manage the property on their behalf. Direct property investments in the UK student accommodation sector have delivered yields upwards of 10% p.a. There are also a number of funds investing in student accommodation which tend to acquire whole blocks, which investors taking a stake in the fund. The Brandeaux Student Accommodation Fund has delivered an average annual yield of 9.71% p.a., and the Mansion Student Accommodation Sterling Fund delivered an annual performance of 12.14% in 2011.

Care homes – Another niche sector that is gaining popularity amongst both institutional and private Investors is care homes, as both seek to correlate the performance of their investments with trends in socio-economic fundamentals such as an ageing global population, and capture financial gains from increasing demand for assisted living accommodation. Investors may purchase units within custom care accommodation and assign day to day management to an operator, or they may choose to invest in a fund specialising in such assets. Direct investments in care homes offer the potential for capital growth and in many cases a “guaranteed” rental income of around 8% p.a., although most opportunities for private Investors tend to be pre-construction projects, adding significant counterparty and strategy risk. Access to investment funds specialising in care homes is severely limited for retail investors, and therefore there is no credible performance data.

This is an excerpt from DGC Asset Management’s Alternative Investments Guide. Free to download at the DGC Asset Management website.

It wouldn’t be overstating the country’s historical importance to call Azerbaijan one of the very few cradles of human civilization in the world, and yet it remains a relatively unknown corner of Central Asia on the world stage.

The history of the nation is punctuated by ancient civilisations and a progressive nature that has seen Azerbaijan embrace and foster culture, the arts and democracy often more readily than many other states in the Muslim world. As the country re-establishes its prominence as a leading global oil and gas producer, so it has also seen a re-emergence and re-discovery of its rich cultural and artistic heritage. Azerbaijan’s hosting of the 2012 Eurovision Song Contest is a showcase event of just how far the country has developed in recent years.

Rich in more than just culture and history, Azerbaijan’s significant oil and gas reserves, as well as promising potential in the alternative energy sector such as wind, hydro and solar generated power are creating exciting investment opportunities to invest in Azerbaijan. The frontier investor unfamiliar with the country may do well to note that foreign investors are already thriving in what continues to be a hotbed for natural resource companies and supporting sectors, but also for technology, transport and infrastructure.

At the centre of all of this vibrant development is the country’s capital and business hub, Baku. Often dubbed “the next Dubai”, Baku is a thriving city, a poignant juxtaposition between the very old and the very new. The UNESCO world heritage site of the Old City sits against a backdrop of new glass and steel skyscrapers that are beginning to see Baku resemble the skylines of New York, Dubai, Hong Kong and Singapore. Foster + Partners, the critically-acclaimed and award-winning architectural firm of Sir Norman Foster, is busy at work with master plans and building designs that will rejuvenate some of the more run-down areas of the Soviet-era city developments.

Since becoming an independent state in the early 90s and beginning work on what was dubbed “The Contract of the Century” with the international consortium of oil and gas companies led by the UK’s BP, the growth of the Azerbaijani economy has been nothing short of phenomenal. Since declaring independence, the economy has grown over 500 per cent and the country survived the recent global financial crisis and subsequent recession relatively unscathed compared to some of its Central Asian neighbours. The greatest attraction for investors however is that Azerbaijan remains a relatively undiscovered market, leaving sectors outside oil and gas still open to significant growth and development.

Foreign investors are becoming a more common occurrence in Central Asian economies, and if there’s one country that deserves the growing attentions of the frontier market investors, it most definitely should be the exciting cultural and economic melting pot that is Azerbaijan.

Paul Henderson is an experienced frontier markets investor and has previously lived and worked in Central Asia for several years. He is currently an Associate with Sturgeon Capital, the leading investment management specialist focused on Central Asian markets.

The $32 billion Harvard University Endowment Fund, which generated a return of 21.4% in the fiscal year 2011, has 23% of its investments held in real-assets, which according the CEO of Harvard Management Company; Jane Mendillo, has been a significant contributor to the fund outperforming its benchmark over the last decade by 270 basis points per year, adding roughly $15 billion of value versus what would have been earned by a more traditional portfolio. The University of Notre Dame also holds a significant proportion of its portfolio in real-assets (17.5%), and delivered a return of 21.5% in 2011. The Yale University Endowment Fund delivered a return of 21.9% in 2011, and holds 29% of its portfolio in real-assets, including real estate and natural resources.

This article seeks to review the investment performance of a range of real-assets, compare that performance to the performance of UK equities, and establish the effect of real-assets on the performance of investment portfolios. In particular, this report focuses on the investment performance and impact of farmland, forestry, gold and fine wine. The following analysis suggests that the low correlation of real-assets with other asset classes means that such investments, whilst potentially illiquid, offer an opportunity to reduce risk and volatility whilst also carrying significant potential to generate superior returns.

The following chart demonstrates the compound annual growth rate associated with a range of asset classes over a range of timeframes assuming a single investment made at the beginning of each measured period and ending at the end of 2011. In the case of the IPD UK Forestry Index and IPD Rural investment Index, data was only available until the end of 2010, however anecdotal evidence suggests that performance throughout 2011 has continued at a similar pace and therefore we feel this still offers a true and fair comparison with the equity indices.

Compound Annual Growth Rate (CAGR)

FTSE 100

Gold
UK Farmland
UK Forestry
US Farmland
US Forestry
Fine Wine

FTSE All Share

Cash

5 year

-2.2%
19.4%
12.0%
17.7%
11.9%
4.7%
10.7%
-2.4%
3.8%

10 year
0.7%
18.7%
10.0%
10.4%
14.7%
7.5%
11.7%
1.3%
4.1%
15 year
6.2%
9.9%
-
-
11.9%
7.2%
-
2.4%
4.4%
20 year
6.2%
7.6%
-
6.3%
11.0%
10.1%
-
4.5%
4.8%

This chart tells us that, broadly speaking, real-assets have outperformed UK equity indices and cash over every period considered. Interestingly, equities is the only asset class examined that generates a financial loss over any given period, indicating a higher degree of volatility than its real-asset counterparts. The timing of this analysis plays some part in forming that conclusion due the impact of the recent financial crisis being included in the 5-year performance data. It is likely then that holding real-asset investment alternatives such as farmland, forestry investments, gold and fine wine throughout a range of timelines will have improved portfolio performance without dramatically altering – and in some cases improving – the overall risk profile.

It should be noted that, in the case of the FTSE 100 and FTSE All Share Indices, these numbers offer only a broad view of the performance of an investment in an index-linked investment vehicle, and do not take into account the upside and downside potential of managing a basket of equities and relying to an extent on picking specific stocks in the hope of ‘beating the market’. Nor does it take into account dividend income which could be re-invested, effectively compounding returns and losses. Investment Managers and Investors might feel they are able to outperform the Index through careful stock-picking and active trading/management, although many studies have shown that, over the long-term, professionally managed equities perform only marginally better than the Index in general, and Investors remain exposed to the likelihood or otherwise that individual investment managers will perform consistently throughout the entire term of an investment.

In this report we have compared the investment performance of a range of asset classes including UK equities, farmland, forestry, fine wine and gold bullion. We have also analysed the effect of portfolio diversification through reducing equity exposure and acquiring real-assets. This report has shown:

Real-assets may contribute substantially to traditional stock portfolios
Real-assets have outperformed UK equities by some considerable margin over every timeframe measured
Exposure to real-assets adds meaningful risk reduction, especially during periods of underperformance or volatility in traditional financial assets

It is clear then that diversification achieved through reducing equity exposure and allocating capital to real-assets has, in the cases reviewed in the this report, improved the overall performance of investment portfolios and reduced risk (considered as volatility) between 2001 and 2011, effectively optimising portfolio performance.

One issue with this basic analysis would be a lack of access to investable projects or assets that give smaller Investors direct exposure to the fundamental characteristics that drive returns in the real asset space. Often, farms and woodlands are too large and expensive for single Investors to purchase, and the specific expertise required to improve, develop and operate those assets is also expensive and hard to come by. It is therefore difficult for Investors to allocate smaller sums of capital to these assets outside of restrictive and often expensive and opaque collective funds. Whilst some funds do offer limited access to certain assets, the structure of such arrangements often hamper asset selection, development and management to such an extent as to deliver much smaller returns than direct investments, as revenue is often absorbed into the cost of the structure and on-going management.

Thios article is an excerpt from a report by David Garner is Partner, Investment Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors. To download the full report, please visit the DGC Asset Management website.

This article addresses some of the risks associated with real-asset investment alternatives in general.

As with any potential transaction, all investments carry risk, and in the case of alternatives those risks are often very specific to the asset class, here we address some of the general risks associated with moveable and immoveable properties considered as alternative investments. This risk-set can be broadly defined and categorised as:

Sector Risk
Location Risk
Asset Specific Risk
Counterparty Risk

Sector Specific Risk

As is the case with traditional financial investments, hard-assets carry risks specific to their sector. For example, in the case of agricultural land, Investors must be aware that a variety of exogenous variables can affect the investment performance of the property. Weather, commodity prices, the cost of farming, and agricultural inputs all factor in the revenue potential and profit margins of a farm. As farmland values are dictated primarily by the income producing potential of the asset, poor on-farm performance can adversely affect capital values. The same can be said for gold; during period of growth in equity markets, gold values may fall as confident investors sell their gold and buy into equities in order to capture returns from raising markets. Subsequently gold values may fall as a result. In the case of timber properties, poor house building figures result in a fall in demand for construction timber, and in these circumstances Investor may not be able to secure the price they require for their timber, and may ultimately leave their trees to continue to grow throughout the downturn, choosing instead to harvest when prices are more buoyant and capturing the extra physical growth that has occurred in the interim.

Location Risk

In many cases, especially in the example of real-estate related investments, Investors may choose to acquire assets in countries other than their own domicile. Asset values in emerging markets are often lower, along with the price of labour, and demand in those markets might also be higher, so acquiring assets that form party of the emerging market supply chain is often a strategy to capture superior returns. Whilst man overseas locations offer security of ownership and a transparent business environment, any overseas investment carries risks specific to the country of operation, and developing economies often carry a much greater risk of political interference or security of ownership issues. This extra risk must be factored into the due diligence process, and the potential returns on offer weighed against this inherent risk to capital.

Asset Specific Risk

When acquiring a tangible asset, it is imperative that the investor has access to the requisite skill-set in order to properly identify any issues with the asset itself. This kind of due diligence is essential in order to establish value of money, and avoid costly investments into otherwise useless assets. In the case real estate based investment alternatives, there may be issue with title, access, planning or even financial issue like outstanding tax bills. In the case of niche property like farmland or forestry, there may be specific issues relating to soil quality or water supply which may ultimately cause the property to be less productive and profitable. In the case of other niche sectors like fine wine or collectibles, very specific experience is required in order to identify genuine investment opportunities, and Investors without access to quality, experienced advice may end up purchasing valueless assets for unscrupulous sellers out to make a quick buck.

Counterparty Risk

When investing in niche products, Investor will usually require the services of a professional to advise on the transaction, but also to operate or manage the assets as is the case with real estate or other assets that require ‘trading’ in order to capitalise on opportunities and minimise risk. In these cases, the investor is exposed to the professional capabilities and honesty of their partners, be they forest managers, fine wine investment managers or collectibles experts. Poor advice at the point of investment and bad or incapable on-going management can ultimately destroy the investment potential of any asset. Proper due diligence is required in order to establish the track record of all partners in their respective fields.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

This article focuses primarily on real-asset investments, and this section is designed to highlight some of portfolio planning characteristics of physical assets when considered as part of a well-diversified and balanced portfolio of investments, as well as some of the inherent risks to be considered when allocating investment capital to specific, niche investment sectors or projects.

Whilst real or hard-assets offer a number of significant benefits including reduced volatility, tangible asset values and the potential for superior investment performance that is not reliant on the performance of traditional financial investments, potential investors must give equal consideration to the potential for relative illiquidity, operational or management risks specific to the asset class, and of course counterparty risk exposure when investing in assets that require on-going expert management in order to maximise returns and minimise downside potential.

Portfolio Planning Advantages

Every asset class exhibits different characteristics when considered from the point of view of an Investor or Financial Planner, and Investors invariable choose to invest in specific assets in order to achieve specific goals such as risk mitigation, portfolio insurance, superior returns and a hedge against inflation or some other potential economic impact on the value and performance of their portfolio.

Here we look at some of the broad portfolio planning characteristics associated with a range of physical assets considered as alternative investments.

Capital Values

By their very nature, physical assets retain a disposal value throughout most economic circumstances, and whilst asset values will fluctuate from time to time, Investors allocate capital to hard-assets in order to underwrite the value of their portfolio and insure against the possibility of the values of listed financial assets falling sharply at any given moment. In fact, certain assets such as gold hold a ’safe-haven’ appeal, often rising in value when stock markets falls as Investors sell equities and buy gold.

Non-Correlated Returns

The fundamentals that support value growth and income associated with real-assets are often far removed from the fundamentals that support traditional investments. Often, alternatives share a direct negative correlation with the performance of equities and bonds, affording investors the opportunity to balance their portfolios and make gains when other portfolio components lose value or underperform. This strategy is sometimes referred to as portfolio insurance.

Diversification

Key to risk-mitigation in financial planning, diversification simply means spreading ones investment risk across abroad selection of holdings, reducing the likelihood that too many eggs are held in one proverbial basket. Diversifying an investment portfolio into a range of holding across different sectors and assets reduces the risk that poor performance in any one asset will have too big an impact on the portfolio as a whole.

Inflation Hedge

A number of alternative investment assets share a strong positive correlation with inflation, rising in value faster than the prevailing rate of inflation. This effectively mitigates the impact of inflation on the real value of investment portfolios. Pension funds and university endowments, along with insurance companies and other institutional investors buy into long-term investment assets such as farmland and forestry for this very reason.

Superior Returns

As detailed in the chart overleaf, many alternative investment assets have outperformed traditional investment assets over the long-term by some considerable margin. Whilst all sectors and strategies carry inherent risk, carefully selected and well-managed real-assets have been shown to generate superior investment returns for the Investor capable of tolerating short term price fluctuations and long-term investment horizons. Operational asset like property also generate income useful when other income assets like cash deposits underperform.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

It is now a widely held belief that investing in stocks and other financial instruments in the traditional manner generates an investment return that is driven more by the latest piece of political rhetoric, or the most recent announcement of sovereign debt risk or unemployment figures from some far flung corner of the world, than by underlying company fundamentals like good management and a strong balance sheet. Aside from this inherent volatility, many investors also feel over-exposed to financial markets, especially those coming close to retirement that may have little time left to regain catastrophic losses in any one holding.

This shift in mind-set amongst investors has driven a huge growth in alternative investment management, with most financial institutions now offering investments that are organised and managed in such a way as to attempt to avoid volatility, or generate a return when markets fall, or some other such strategy.

Short Only
Short only funds bet on particular stocks losing value. Investors might buy into a short only fund if they felt particularly bearish (pessimistic) about the short term future of financial markets in general, and some may allocate capital to this strategy as a hedge against the impact of a general downturn.

Ultra-Short Bond Funds
This a type of investment fund that invests fixed-income bonds with very short-term maturities. Such a fund will usually invest in bonds with maturities of around 12 months. This strategy is designed to generate higher yields than traditional bond investing with less volatility.

Market Neutral
Market neutral is an alternative investment strategy designed to profit from growth and depreciation in the value of stocks. Whilst there is no finite technical definition for market neutral investing, for the most part, the overall strategy will involve taking long and short position in a stock (betting both for and against it) in order to maximise the return from making good stock selections and minimise the impact from broad market movements.

Absolute Return
The original name for hedge funds – absolute return investing involves a wide variety of alternative investment management techniques designed to capture financial gains during any and all market conditions. Absolute returns refer specifically to the return of the fund or investment over a given period of time i.e. the actual growth or depreciation. This differs from relative returns, which is a measure of investment returns when compared to similar investments or a sector.

Long / Short
A true mixed bag of investing, long short strategies involve taking long positions in one stock and betting against the value of another stock. In theory, as one sector or company makes a gain, there will be losses in competing sectors, and investment manager aim to identify such opportunities and capitalise on them. A broad example might be an investment manager who thinks oil prices will rise significantly based on some impending political or social crisis, so they might buy into oil company stocks and short stock of companies that rely heavily on oil as a key input in their business.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

Ask any experienced investor over the age of 50 what type of real-asset they wish they’d invested in when they were young, and the vast majority will most likely give one or more of two answers; gold and/or real-estate, and those who pay more of an interest in such matters might even whittle their selection down to niche agricultural real estate including farmland and timberlands. Why so then would anyone with 30 years of investing experience behind them, having seen rise and fall of many fads, bubbles, booms and busts, consider physical, tangible and useful assets in precisely the same light as the wealthy of centuries gone by, when value was literally only stored in land and precious items like gold and jewels?

OK, so put aside for a second that the recorded investment performance of farmland and forestry investments has outperformed the vast majority of traditional assets like equities for decades, it is now becoming ever-more apparent that the sensible investor, especially those who have been party to the consistent volatility in financial markets over the years, is choosing to acquire assets that retain a use and essential function, and where demand is growing and availability of suitable resources falling. These assets will always be in pretty high demand, as growing populations shift to a higher protein, more resource-intensive diet, and general population growth requires increased output of agricultural commodities for food and biofuel markets. It is likely then that these assets, especially those that produce essential food commodities will continue to grow in value over the long-term, and that the income derived from them also rises as competition in the grain markets intensifies at an international level.

Timber is a great example of an asset class which, if well-funded and expertly managed, continues to grow in size physically regardless of growth in financial markets or the economy at large. It is primarily this fact that makes forestry investments so popular amongst long-term investor like pension funds, university endoements and insurance companies. Demand for sustainable sourced timber is growing exponentially, and curbs on the illegal logging trade along with international legislation to protect natural forests will continue to push up the value of any timber grown, so not only does the asset grow bigger, it also grow more valuable per weighted measure, creating a double-pronged growth strategy to combat otherwise volatile market-linked portfolios.

However, it should be noted that there is no such thing as the perfect investment, and real-assets in niche markets carry very specific risks of which potential investor must make themselves aware. Education is key to wealth preservation, and whilst risk cannot be eliminated, it can be identified and in most cases mitigated through proper structuring and management of a property or investment. Investor are encouraged to seek advice of an experienced advisor able to demonstrate a track record of identifying and delivering successful project, and who is capable of providing the investor with up to date, credible and factual asset class analysis in order to properly acknowledge and understand the asset specific risks that may eventually impact the investment performance of the asset or project.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

There are a number of reasons that seasoned investors chose to invest in alternative assets; mainly of course to diversify in to assets where investment performance is not driven by the performance of financial markets in general; but also in order to capture capital gains and income to replace ailing and volatile equities.

The appeal of real assets like farmland, timberlands, real estate and other, more esoteric assets like fine wine and collectibles, lies in the fact that these assets are all tangible properties, that are likely to retain the majority of their value, and continue to generate income, regardless of whether stock are up or down. The general consensus is that an investment portfolio consisting entirely of stock, bonds and cash is grossly over-exposed to the day to day vagaries of ‘the markets’.

Choosing a good stock has become less about the basic underlying fundamentals of the company, and more about market sentiment related to the sector or markets as a whole, and it is this investing environment that pushes investors to seek returns elsewhere, whilst underwriting the value of a portion of their portfolio with capital assets like land or property.

Another good reason that interest in investment alternatives seems to be peaking, is the poor annuity rates offered to new pensioners by insurance companies. In every case, new pensioners are being forced to fix their incomes at a much lower rate than they had previously been able to do, causing many to readdress their future lifestyle choices and standard of living. This alone is motivation enough to seek out assets that retain their value whilst also generating an income to beat that of their deflated pension plans.

Pension Funds, University Endowments and Insurance Companies are mostly increasing their exposure to real asset alternative investments, with many making large purchases of farmland and forestry investment properties, and now Financial Advisors seem to be coming on board too, searching for secure and transparent alternatives for their Clients.

Making the most out of an investment portfolio is not just about picking the best stocks, but about investing in a range of assets to ensure that a blip in the market does not completely destroy the intrinsic value at a time when the investor may not have sufficient time on order to recover their losses before retirement. But investors should remain aware the real assets carry sector, asset, location and counterparty risk, and these risks must be properly acknowledged and understood in order that the investor does not expose themselves to risky assets that might be badly managed, which ultimately defeats the whole object of alternative investments diversification.

Investor and Financial Advisors are encouraged to seek the assistance of a professional Advisor with experience of identifying, measuring and delivering alternative investment projects, and who should be happy to provide references from happy Clients, and proof of their successful track record.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

It’s been a tough time for investors lately with the world’s major sharemarkets struggling to produce any meaningful capital gain over the past five years.

The disappointment, though, goes deeper: since the start of this century the US sharemarket, measured by the S&P 500 Index, has fallen by 13 per cent, and that’s before taking into account the erosion in value caused by inflation over that time.

In contrast to shares, world bonds have performed spectacularly well (up over 100 per cent) since 2000. The yawning gap in returns between bonds and shares doesn’t depend on the starting point being 2000 either; you have to use more than two decades worth of (US) data before you can show that shares have delivered higher returns than bonds.

It’s perhaps not surprising then that investors have shifted some of their funds away from shares and into bonds. According to data from over 40 countries compiled by the Association of US Investment Companies, investors have reduced their allocation to shares from almost 50 per cent at the end of 2006, to 39 per cent by the end of September 2011, and upped their allocation to bonds and money market investments.

In making the shift, of course, they have contributed to the downward pressure on shares prices and helped push up bonds.

There are at least three reasons behind many of world’s savers shifting from shares to bonds over the past five or more years:

The obvious one is that bonds have simply delivered better returns than shares – in hindsight the shift in funds has been a no-brainer. But could bonds turn from being a no-brainer to being a genuinely stupid investment over the next 10 years?

Another compelling reason for the shift to bonds is simply a flight to safety. Bonds traditionally offer much greater security over the capital value of an investor’s funds in exchange for a lower return than is the case for shares. Given the huge uncertainty that has dogged financial markets for much of the past five years it’s small wonder that investors have withdrawn to the relative safety of bonds. As the turmoil in financial markets fades investors may be inclined to take on more risk and nudge their way back into shares.

A third reason for the shift to bonds may be more fundamental. The demographic bulge in the number of people hitting retirement is likely to see a sustained shift to more conservative investment mandates. As this large age cohort retires their focus will be on the security of their capital rather than the returns they can get from that capital. If the financial crisis has taught us anything it is that returns that look too good to be true, too often are. For New Zealanders that message was repeated loudly by the collapse of finance companies that had lured many retired folk to invest in dubious debentures by offering unsustainably high interest rates.

The first two reasons above rely heavily on hindsight, something that investors find very difficult to shrug off. Investors are told time and again that over the long run shares will produce higher returns than bonds; the basic rationale being that shares carry more risk and therefore investors seek higher returns.

Well, as we’ve seen that has not been the case for the past decade or more, which raises the question: how long is the long term? For a 65-year-old, 10 years may be all the time he’s got left, whereas a 25-year-old can afford to hang on for long-term relative returns to prevail – shares outperforming bonds.

Interestingly, a major KiwiSaver provider has argued that too many Kiwi savers will miss out on investment returns by spending the rest of their working life in the conservative funds they have been defaulted to. The argument rests on these conservative funds returning less than more aggressive share-oriented funds over the longer term.

While past returns are not necessarily a good guide to future returns, the experience of the past two decades surely tell not to make sweeping assumptions about future relative returns. KiwiSaver members who have allowed themselves to be allocated to relatively conservative default funds have done pretty well over the past four years and it would be foolhardy for the Government, or a KiwiSaver provider for that matter, to somehow impose their conviction about future relative returns upon lethargic KiwiSaver members, or indeed presume to know what’s best for individual investors.

Bond yields are historically very low in most, though certainly not all, developed economies. The scope for them to go lower and thus keep delivering the significant capital gains they have done over the past two decades or so is getting pretty slim. Furthermore, if the liquidity central banks have been pumping into their economies finally generates economic lift-off, higher inflation is likely to follow, and that would dent future bond returns. Essentially central banks are trying to engineer an economic recovery by lowering the returns bond investors get in favour of higher returns for businesses taking on debt to expand their business or leverage their existing business – either way cheaper credit should translate into higher share returns eventually.

It would be a pity to see investors once again driven by hindsight to desert an asset class (in this case shares) as it passes through the bottom of its returns cycle and plump for bonds as they pass through the peak of their cycle. The shift back to shares delivering higher returns than bonds will happen – if only someone would tell us when!

Gareth Morgan Investments is an Investment Management company servicing clients who want personal and transparent management of their investments. We manage investment portfolios for individuals and institutions, and we are a KiwiSaver and Superannuation scheme provider.

Visit us at: Gareth Morgan Investments

The European sovereign debt crisis has continued to hog the attention of global markets, with little sign of immediate resolution. The latest development in the drama has been a Europe-wide plan to move to a more centralised approach to setting national budgets in the region. This would involve European governments having to stay under certain deficit and debt limits or face fines for breaching them. It was also agreed that the International Monetary Fund (IMF) will play a greater role in helping out financially troubled countries in the region. The hope is that these changes will be enough to give investors confidence to buy the bonds of Eurozone countries, particularly those with high debt levels such as Italy and Spain.

The problem is that changes to the European Union constitution are required. This in turn will require ratification by the parliaments of individual European countries. Britain has said from the start that it will not be part of the latest proposed deal because it is detrimental to the competitiveness of its financial sector. And although the other 26 European nations have given their initial approval to the deal, the fear is that some of them will be unable to ratify it.

In the meantime the financial state of the European banking system has deteriorated substantially. In response to bank pressures, the European Central Bank (ECB) and the US Federal Reserve have pumped an extraordinary amount of emergency short-term funding into the European financial system. So far this has had only limited effect on bank funding costs and credit pressures. However, one side-effect of the ECB actions has been to support European bond markets through the back door. Banks are taking advantage of the cheap short-term funding available at the central bank and then buying European government bonds with much higher yields, thereby making sizeable margins.

Despite ECB efforts so far, many investors and commentators are calling for a “big bazooka” – aggressive ECB buying of Italian and Spanish government bonds. This would lower the interest rates Italy and Spain pay on their debt even further, making the debt easier to service. It would help support the value of those bonds, helping to protect the capital of European banks. But Germany, and the ECB itself, is vehemently opposed to such action. Their fear is that lowering the interest rates on European sovereign debt will take pressure off governments to undertake the reforms required to get their finances on a truly sustainable footing.

So the crisis stumbles on. My view is that the situation will muddle along until such time as markets have sufficient confidence that Eurozone members are on the road to consummating a European fiscal accord. This could be around March/April next year. In the meantime the ECB will continue to provide backdoor support for sovereign bond markets, although this may become more direct once the accord has been ratified by a critical number of European countries. Europe is heading for recession next year as a consequence of the contraction in bank credit and the uncertainty stalking the financial system.

There remains a small but significant risk that the crisis could deteriorate to the extent that the European banking system begins to crumble – some banks either go bust or have to be taken over by their governments. In this case the ECB, IMF and national governments, in cooperation with other central banks around the world, would intervene massively to support banks. Under this scenario a break-up of the Eurozone and sovereign debt defaults would create havoc in financial markets. Global growth would certainly suffer under such an outcome.

On a positive note, it is now clear that the US is no longer heading for recession. In fact, indicators over the past few months suggest the US economy is gradually building momentum and is likely to reach annual growth of 3-3.5% by the end of this year. And although China’s economy has slowed to around 9% annual growth, inflation has abated, which gives the Chinese authorities room to free up access to credit to stimulate activity. These developments will blunt the negative influence of Europe on global activity.

Europe’s woes will continue to emphasise the risks of excessive debt whether that be government, business or household debt. New Zealand government debt is relatively low, but rising as we continue to run significant budget deficits. New Zealand households are still carrying a high level of debt primarily backed by property. This is the age of deleveraging or debt reduction; we ignore the message at our peril.

Gareth Morgan Investments is an Investment Management company servicing clients who want personal and transparent management of their investments. We manage investment portfolios for individuals and institutions, and we are a KiwiSaver and Superannuation scheme provider.

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