Our investment beliefs
A set of beliefs, a philosophy, a modus operandi – call it what you will – is not something you can discover overnight. It’s best developed over time. The things we’ve come to believe about funds management are the result of years of experience and being curious.
Over the years, new thoughts and ideas have been added to older ones, new things have been tried, new connections have been made. From all this seeking and sifting, something strong is built – a multi-layered arrangement of tenets and values.
Here, we offer you the basic ‘six pillars’ which uphold all our beliefs. These are the guiding principles that inform most of the investment decisions we make.
We believe they are tried and true. We like to think we are too.
Key belief number one: Markets work
What is a market? If you were able to subject it to microscopic analysis, you’d see that the fundamental ‘market atom’ consists of three people. Two people can trade with each other, but it takes at least three to form a market. That’s because there needs to be competition on at least one of the two sides.
Competition is everything. It is to a market what wind is to a kite – it supplies the energy that makes it fly. The more buyers and sellers you have in a free market, the more competitive it is.
You often see markets referred to as being ‘beautiful’. There is certainly something harmonious about the way a market moves freely, co-ordinating and correcting itself. It does this naturally, without central direction and without fear or favour. It isn’t a living thing, but it can appear so in its responsiveness and ‘no-day-is-the-same’ behaviour.
The global financial markets – made up of the world’s stock markets, bond markets and others – are where the world’s investment capital gets channelled to corporations and governments. In this way, money from investors fuels growth around the world. Investor returns are, in essence, a share of that growth.
It all works. It all works with extraordinary efficiency. The prices investors pay for stocks, bonds and the like are always changing as conditions around them change (e.g. government actions, business performance). Although prices can take time to adjust, the intense competition among the buyers, and among all the sellers, means it is unlikely any single investor will profit at the expense of the others.
These markets can appear to be an ever-shifting kaleidoscope – a day-to-day scramble of up, down, all over the show. But beyond the short term gyrations, a more orderly long term pattern can be detected.
Capital markets march steadily upwards. Historical performance graphs offer proof of this. Looking back, we can see retreats and setbacks, but the overall trend for more than a century has been one of inexorable growth. Why? It’s the way capitalism works. Because the world’s economy continues to grow over the long term, so too does the wealth generated by its capital.
That’s why taking the long view is so important for investors. Here’s an example:
Back in 1993, an investor makes a $10,000 investment in the New Zealand share market. Twenty years later that capital investment is worth over $50,000.
That performance is despite massive market downturns after the Asian crisis in 1998, September 11, The Tech Crash in 2002 and the GFC which began in 2007.
This example is for illustration purposes only. It shows the hypothetical return of an investment of NZ$10,000 in the New Zealand share market since 1st January 1993. It assumes all dividends and capital gains are reinvested. Past performance is not indicative of future performance. Source: AMP Capital
‘What goes up must come down’ is a law of nature. But it doesn’t apply to the investment markets over the long term. Markets certainly work. And we believe it’s important to know how they work.
Key belief number two: Risk and return are related
Is there such a thing as a risk-free existence?
Not on the planet we happen to inhabit right now. One way of looking at life is to see it as a pathway along which we negotiate risk after risk. Will taking this job hurt or enhance my career? Can I hold off painting the house another year? Should I wear that Hawaiian shirt to my daughter’s 21st?
Interesting observations on risk management can be drawn from many walks of life. A good example is avalanche risk. Avalanches are a known risk, they are anticipated, but their timing and severity is unpredictable, and therefore similar to investment market risks. They are typically managed in the following way:
Learn about avalanches in general – study prior events to understand likely conditions.
Learn about specific conditions at the time.
Create damage control strategies.
It is better to employ all these techniques wisely than to focus on one. The investing world is also similar in the need to focus on a range of investment risks and develop a range of coping tools to manage these risks.
So it should be, for what is at stake is not something trifling, but someone’s life savings.
Investing always means taking a risk (it’s important to remember that not investing means taking a risk too). How that risk is managed is crucial to successful investment.
Investment risk comes in a range of sizes. At the bottom end of the scale there are 5-year government bonds. Investment professionals often describe these as a ‘risk-free’ investment. That’s not strictly true. What if New Zealand was invaded tomorrow and subjected to totalitarian rule? (Highly unlikely, but not entirely impossible.) What can be said is that a New Zealand government bond is about as safe an investment as a New Zealand investor can get.
At the riskier end are stocks (shares), especially those from what we call emerging markets, e.g. countries such as India and Brazil. In between are other fixed interest options, property, other share markets and so on.
Just as each of these asset classes differs in risk, they also differ in return potential. That’s where risk and return are related – generally the greater the risk of an investment, the higher its potential return.
This is well known by all investment managers. What differentiates them is how they act upon that knowledge.
We believe that protecting the capital our customers have invested with us is of paramount importance. So we emphasise the risk side of the equation, rather than some promise of a fabulous return.
This rigid risk philosophy can be seen in our always hedging offshore bonds back to New Zealand dollars, to negate the effect of currency fluctuation. It can be seen in our avoidance of any fixed interest investment that doesn’t have an investment grade credit rating. And it can be seen in our preference for asset types with low risk characteristics such as property and infrastructure assets.
This approach requires discipline and no small amount of humility. We don’t claim to know how a market will perform, and we think those that do are false prophets. We still aim to add value – that’s an essential part of our job. But rather than trying to beat the market, we believe in adhering to the principles that will make it work for us.
Key belief number three: The world is a risker place than you think!
Tail risk, strictly speaking, is an observation in the tail of a probability distribution, but in layman’s terms means an unexpected loss of large proportions. The Executive Director of FANZ provides the example of the “One in a Hundred Year Flood” that Invercargill received in 1978. The problem was they received another “One in a Hundred Year Flood” in 1981! This type of investment experience can occur at two levels. Firstly, at an individual investment or strategy level, so for example an investment manager experiences a significant loss related to a position or positions held in the portfolio. Secondly at a portfolio level, which is typically related to an asset bubble bursting or some other form of systemic risk that affects macro-economic variables and markets more broadly, and can have a significant impact across an investor’s portfolio.
Tail risks are also referred to as “fat tails”, which relates to the non-normality of most return distributions, and the greater likelihood of observations occurring in the tails of the distribution.
Using a conservative assumption to overlay any decision process that relies on the normality of market behaviour will help investors from falling into the trap of not recognising the higher frequency of large negative or positive observations, and establish realistic expectations.
Look at what has happened in investment markets since 1990.
1990: Invasion of Kuwait by Iraq. Dow Jones falls 50%.
1994: New Zealand Bond Crash
1998: Emerging Markets Crisis
2001: September 11 Terrorist Attacks
2002: Tech Crash
2007: GFC Begins
We do not know what the catalyst will be that will lead to the next market downturn but we do believe that one will occur in the future. It makes sense to reflect this in portfolio construction and to be aware of the risks inherent in your portfolio.
Key belief number four: Diversification is essential
We all have meals we adore, even crave. Perhaps it’s fish and chips. What’s not to love about a battered fillet and a scoop of golden chips? So why don’t we eat fish and chips all the time?
We know the reasons why. The excitement would quickly wear off. We’d start feeling unwell. And what we’ve always been told would come to pass: by depriving our bodies of a balanced diet with lots of different foods, our health would start to go downhill.
The same applies to investment. Too much of what might at first seem like a good thing will not sustain the well-being of your capital over the long term. A varied investment menu is vital. Diversification, as we call it, is the single most important principle in investment portfolio design.
The reason for this is not hard to grasp. Wherever there is risk, by spreading it you take some of the sting out of it. That’s what diversification does. For example, if you put your savings into a single stock, you’re concentrating your risk. You’ll sink or swim on the performance of that one company. Should it plunge in value by 40% during the year such things happen – so does the value of your entire savings. But if you bought 20 different stocks, a poor performance by one or two or even more could be offset by the gains of the others. Your overall return will always be higher than that of the worst performing stock.
By controlling risk in this way, diversification reduces uncertainty. And when it comes to investing your savings, who wants uncertainty? Every fund manager talks diversification. All have different ways of going about it. (That’s right – diversification itself breeds diversity!) The standard offering sees a spread over different asset classes and economies around the world. We believe in dicing things even further.
So we also diversify across asset classes and across managers. But we don’t diversify simply for the sake of it. Markets are in a state of constant flux and there are new choices to make all the time. To attempt to ensure the right ones are made, there’s homework to do. At any given time we want our diversification to include the strongest performers. When Dan Carter in his prime is fit and available, you don’t leave him on the bench.
You could say we believe in ‘smart’ diversification.
Key belief number five: Structure determines performance
Investment portfolios, like road vehicles, are designed and made according to different owner requirements. Need something small and nippy to get around town? Or a large, comfortable station wagon for long haul trips? Perhaps a van to haul a team around? These vehicles will all share the basics (four wheels, an engine, and so forth), but beyond that fundamental structural differences will determine very different performances.
With investment, differently structured portfolios similarly lead to variations in performance. When we talk about a portfolio’s structure, we’re talking about its asset mix, i.e. how it is made up of varying proportions of different investment classes. And what determines the chosen mix? The customer’s tolerance for risk is the answer.
In this way, asset allocation works on the same principle as diversification. It’s largely about risk-limitation. What’s different here is that customers have an active role in deciding how much risk they want to take. This is an important conversation we have with all our customers. We find out where their lives are at and what their savings goals are. They are told where each asset class rests on the risk scale. Together, we come up with custom-made portfolios, each with an asset mix designed to suit the investor’s situation and appetite for risk.
As we’ve explained, there’s a strong correlation between risk and return. The asset classes deemed to be low risk also tend to offer low returns, and vice versa. So it follows that a portfolio structured to keep risk at a minimum will generally deliver lower returns than one where the risk threshold has been set higher.
But at the same time, that other structural lynchpin, diversification, does its bit to ensure returns do not fluctuate too extravagantly. We believe that assets can be diversified efficiently enough for potentially higher returns to become possible with little or no increase in risk. Behind every portfolio we design is a desire to create a whole that is much greater than the sum of its parts.
Time also needs to be mentioned here. Any asset allocation plan needs time to succeed, because time is another factor that lowers risk and increases potential returns. We believe time is the undemanding friend of all investors. Given time, time will give.
Key belief number six: Not losing money
High absolute volatility and the occurrence of significant losses can severely impede the accumulation of capital. This illustrates the negative impact of high volatility on compound returns. It is particularly dangerous for those approaching or in retirement. Older investors cannot withstand a significant equity market correction near or during retirement. In a low return environment, for example 6% per annum, it will take 6 years to make back a 30% market decline.
The trick in investing is not to lose money. That is the most important thing. If you compound your money at 5% a year, you’re better off than investors whose results jump up and down, who have some great years and horrible loses in others. The losses will kill you. They ruin compounding rates and compounding is the magic of investing.
Focusing more on the risk of loss brings into consideration “drawdown”, a frequently referred to risk measure when assessing the magnitude of losses and the time taken to recover from them. Drawdown measures peak to trough losses, so the maximum drawdown experienced by a strategy illustrates the maximum amount historically that has been lost. The circumstances under which this occurred are clearly informative. A related piece of information is the time it takes the strategy to make back losses suffered (the “time to recovery”), and underwater analysis, which shows the amount of time spent in drawdown. We include an historical analysis of our portfolios, which illustrates this point. Portfolios that focus on preserving capital in market downturns tend to have smaller periods of time in drawdown.
The FANZ Private Portfolios performance since inception outlined in the table below are a good example of how important drawdowns are:
Annual Performance (pre-tax and fees)
|**Official Cash Rate||Conservative|
|Balanced Portfolio||Growth Portfolio|
*past performance is no guarantee of future performance
The performance returns disclosed are before tax and fees, and are for a sample of our clients. Actual performance for individual clients may vary due to the mix of portfolio and when they invested. Past performance is no guarantee of future performance.
The portfolios have had the following drawdowns since their inception in 2004:
2007 Period of Time to Peak to Trough: One Year
2007 Period of Time to Peak to Trough: One Year
2007 Period of Time to Peak to Trough: Two Years
2011 Period of time from Peak to Trough: One Year
This illustrates the importance of capital preservation in severe market downturns. It also reveals how long it takes a portfolio to recover back to its peak in market downturns. Many advisors focus on returns rather than risk and portfolio value recovery. That is why when the inevitable market correction occurs their clients’ portfolios may take longer to get back to their peak.