Frank Russell Suggests NZ Investors Go Offshore
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Frank Russell Suggests New Zealand Investors Go Offshore, But Warns Australia Isn’t Far Enough.
AUCKLAND, 10 OCTOBER 2000 – Releasing a research paper, to celebrate its $1billion funds under management milestone, Frank Russell Company (N.Z.) Limited provides strong evidence on why New Zealand investors should allocate money offshore – but warns against the normal bias towards Australian shares.
In their research paper, "A guide to the Why and Where of investing offshore – a New Zealand Perspective”, Frank Russell, one of the world’s largest investment advisers, suggests that New Zealand investors are not truly benefiting from global diversification.
time when a merger between the New Zealand Stock Exchange
and the Australian Stock Exchange is increasingly debated,
we believe that many investors are already seeing an
'Australianisation' of the market, with New Zealand
investment managers actively seeking better returns and risk
reduction through investment in Australian shares, says Dr
Craig Ansley, Managing Director, Frank Russell Company
"Yet, we do not believe that exposure to Australian shares is the best way for New Zealand investors to seek better returns,” Dr Ansley said.
Theoretically at least 70% of a New Zealand investor's exposure to the share market should be offshore. Diversification through international investing should provide both better returns and lower risk as it is precisely the differences, and the low correlation between markets, that provides the real benefit.
“When New Zealanders invest heavily in Australia, they don't benefit as much as they could from global diversification as the Australian market is more closely linked to the New Zealand market than any other market in the world," (figure 4 attached) says Dr Ansley.
“It is best to have a portfolio that combines investments in New Zealand with investments in markets that are essentially very different from our own. When one market dips, in many cases, the other does not and investors are cushioned from that exposure to risk. Simply put, the Australian and New Zealand markets share such similar vulnerabilities and risks, that investors are not benefiting from a full risk reduction, " Dr Ansley explains.
Speculation is rife about whether the two stock exchanges will merge, and there are obvious benefits from such a merger, including the improved liquidity of a larger single market, and an improved economy of scale. "There are many reasons why the two markets should be moving closer together including the large number of companies that have business interests in both countries and are listed on both stock exchanges. Whilst there are many benefits to a single market, it is wrong to assume that a merged market, will provide all the benefits of investing ‘offshore’ whilst staying close to home. Both New Zealand and Australian investors will need to look further afield.
“ When we compared the historical risk and return characteristics, we found that a portfolio of Australian and New Zealand shares was clearly bettered by a portfolio of New Zealand and International shares.
In other words, an investor should get a better return for the same level of risk by skipping the Australian market and investing internationally. This then, is the real opportunity," Dr Ansley says.
“Our conclusion is that a portfolio of New Zealand and international shares should provide a better return for the same level of risk than a mix of New Zealand and Australian shares (see figures ). If New Zealand investors want to truly benefit from a diversified portfolio, they should venture offshore beyond Australasia,” said Dr Ansley.
About Frank Russell
Frank Russell, which has operated in New Zealand since 1991, recently reached the $1 billion funds under management position, after adding approximately $NZ800 million in funds during the past two years. Approximately 85% of the assets managed by Russell are invested offshore. Russell invests nearly $NZ500 million through the Ascent Investment Programme, in partnership with ANZ Bank.
Frank Russell, is one of the world’s leading investment services firms with over $NZ2.3 trillion under advice and $NZ150 billion under management on behalf of clients in over 35 countries. It is a key adviser to many large pension and retirement plans for large multinationals and smaller investors alike. In New Zealand, Frank Russell advises the National Provident Fund, ASB Charitable Trust and Earthquake Commission amongst others.
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The statements in the News Release are therefore no substitute for specific individual expert advice.
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Russell Company (NZ) limited
A guide to the Why and Where of investing offshore?
A perspective on investing in New Zealand
The evidence provided in this paper strongly supports an allocation to overseas investments by New Zealand investors.
Since the process of financial deregulation began in New Zealand during the 1980’s more and more New Zealand investors have allocated a significant proportion of their funds to overseas assets. But, why is this so?
We provide an answer to this question by examining some of the benefits to be derived from international investment.
History tells us that:
there is strong evidence to support an
offshore exposure in shares. Theoretically at least 70% of
a New Zealand investor’s exposure to the share market should
the evidence for hedging currency on international shares is mixed. The volatility introduced by currency risk does not add significantly to the riskiness of international shares;
there is a less compelling case for investing offshore in global bonds. Somewhere between 30% and 70% offshore would get optimum results;
it is critical that any exposure to international bonds should be predominantly hedged to New Zealand dollars. This is because currency fluctuations add a significant component of risk to what is otherwise a relatively low risk asset.
So we can see that from a risk management point of view there is a good case for investing offshore. The intuitive reasons for this are that:
the New Zealand market is relatively
small and illiquid, presenting an added layer of risk that
can be mitigated by offshore diversification;
investing offshore allows New Zealand investors to diversify by industry, allowing access to many business sectors that do not operate in New Zealand;
offshore investment mitigates an individual’s exposure to the domestic economy.
Russell's experience with major institutional investors has provided insights into the benefits derived from investing in overseas assets, and the methods of getting that exposure. Our conclusion is that overseas investments provide both risk reduction and the potential for long-term incremental returns. We believe that offshore fixed interest assets should be predominantly hedged to New Zealand dollars, but the case for hedging shares is less clear. Since currency does have a great impact upon the risk/return profile for international shares, investors are able to consider secondary criteria, such as minimising regret. After allowing for these secondary criteria, we conclude that the optimum currency mix for international shares is 50% hedged.
This paper examines the case for investing a portion of a New Zealand investor’s assets overseas. In this context, we review the international investment environment and outline the role of international investments for New Zealand investors. We also consider currency effects, and how forward currency contracts can be used to enhance risk and return characteristics. In this paper we:
draw conclusions from modern portfolio
theory on the benefits of diversification;
discuss the overseas investment environment in terms of the available investment opportunities, historical investment returns and volatilities, industry sector weightings and inter-market correlations;
explore the potential for reduced volatility and incremental returns from overseas investment;
evaluate optimum strategies for managing currency exposure.
The Benefits of Diversification
The key to successful investment is the efficient management of risk. Modern portfolio theory demonstrates that the more broadly investments are spread across markets, the more the risks associated with these investments can be diversified away. By spreading investments broadly, the investor can be sure of minimising the risks taken to achieve a given target level of returns. Broad market coverage, therefore, should represent the default investment stance of a fund.
By investing across asset classes, an investor is able to maximise the return they can achieve for a given level of risk. They can also ensure that the risk they bear is consistent with their objectives and risk tolerance. By investing across national boundaries, an investor can participate in the growth of the world’s economy, without applying judgement as to which country’s economy will perform better in the future.
A brief history
New Zealand has always been an outward looking country. Our colonial past, combined with the necessity for international trade has obliged us to pay close attention to international markets. But it wasn’t until the early 1980’s that restrictions were lifted on offshore investment. The move to a floating exchange rate in 1985 immediately precipitated changes in the way we invest in terms of both asset and currency exposures.
US investors began to invest in non-US markets with significant commitment in 1975. In the UK, the removal of exchange controls in 1979 marked the beginning of an unprecedented move into international markets. The average international content of UK pension funds is now over 20%.
Figure 1 outlines the median allocation of New Zealand wholesale balanced funds to overseas assets at the end of the calendar years 1993 to 1999.
Overseas Equity and Fixed Interest Allocation Median of Balanced Funds
One Year Periods Ending 31 December 1999
Source: Frank Russell Company
At the end of 1999, the median New Zealand balanced fund manager had 28.7% of total assets in overseas equities and 10.6% in overseas fixed interest.
The global sharemarket
We don’t always appreciate how small New Zealand is in the world economy. Over 99.9% of the world's equity capital lies outside New Zealand - a compelling case for at least some overseas investment. Figure 2 below illustrates this fact, using data as at 31 December 1999.
Distribution of World Equity Market Capitalisation
31 December 1999
Source: MSCI World Index
Like all local investors, New Zealander’s have found that the domestic market has provided superior returns for only limited time-periods. The following table displays a comparison of investment results for New Zealand and some of the major international markets. The New Zealand market was the best performing equity market in 1983 and 1986. The US market has been the most dominant over the latter part of the 1990’s.
Best Performing Markets ($NZ)
Source: Annual data from MSCI country indices and NZSE 40 Gross, returns calculated in NZD terms
Diversification through international investing should provide both better returns and lower risk.
reduction stems in part from the differences in the
economies of countries (e.g. resource exporting, resource
importing) as well as different industry profiles. The New
Zealand market, being very sector specific, provides a good
case study for the benefits of risk reduction. Figure 3
below compares global industry sector weightings of listed
companies, with those of the New Zealand market. It
illustrates the preponderance of the Services and Materials
sector (this includes Telecommunications and Forestry). It
also highlights the relative scarcity of shares in the
Capital Equipment, Consumer Goods and Finance sectors.
Industry Sector Weights
31 December 1999
Source: MSCI World Index, and NZSE 40 Gross Index
Low correlation of performance between individual markets results, in part, from the above-mentioned differences in economic orientation. Consequently, international diversification provides a large risk reduction factor. Even considering the growing trade dependency between major economies, equity markets remain heavily driven by different forces including, in part, the behaviour of their local investors. The effect of local investors in New Zealand is somewhat less than in other markets. This is largely due to the relatively high overseas ownership of the New Zealand market. As at July 2000, around 54% of New Zealand equities were owned by overseas investor, a decline from the 61% offshore ownership in 1997 . Nevertheless these impacts, as well as currency volatility, will continue to hold down the correlations between markets.
Figure 4 below presents evidence of the low correlation between the NZSE40 Gross Index and the national equity markets of a number of the world's largest economies. It plots the range of values for the correlation coefficient over a number of 10 year periods; showing that the inter-market correlation has historically fluctuated around a low level. All correlations below 0.5 are considered good diversifiers.
Correlation Between NZSE 40 Gross Index and Other MSCI Equity Markets
Range for 10 Year periods Ending 1981 – 1999
Source: Quarterly data from MSCI Indices and NZSE 40 Gross Index
New Zealand Vs Australia
A common theme amongst New Zealand based investment Managers in recent years has been the Australianisation of the New Zealand market. Managers argue that widening their mandate for NZ equities to include an exposure to Australian equities will improve returns and reduce risk.
The case for additional returns is not strong. To follow the logical course of the argument we begin by examining the case for including New Zealand equities. As we have established, the New Zealand market comprises a negligible part of the world’s equity markets. So why have any at all?
One argument might be that New Zealand managers can add more value in the Australian market than they can in the global marketplace. This argument is seriously flawed on two counts.
First, why assume that New Zealand managers can add more value managing Australian shares than Australian managers can? It is hard to find any reason to believe that New Zealand managers have any advantage over Australian managers, who will generally spend more time, energy and resources researching the Australian market. And it is relatively simple for New Zealand investors to hire Australian managers.
Second, why should investors limit themselves to New Zealand or Australian managers? The reality is that New Zealand is a very open economy, and New Zealand based investors can gain access to practically any manager in the world. If we assume that investors have the means to differentiate between good and bad managers world-wide, there is no reason to restrict choice to that small set of managers that base themselves in New Zealand. And New Zealand investors will be motivated to look for the best opportunities.
Another argument might be that the imputation system allows New Zealand investors to obtain tax benefits from investing in the New Zealand market, that they do not obtain from offshore markets. This argument makes good sense, especially since the dividend rate on NZ Equities is unusually high. And the high proportion of foreign ownership ensures that investors that do not have the same advantage largely set prices. We demonstrate the point with an example.
Suppose that international investor’s priced equities so that the expected rate of return was 15% pa. Those same investors choose to invest in New Zealand in the expectation that they will obtain at least the same return, around 15% pa. The dividend yield from NZ Equities is 5% gross. But if 80% of dividends are fully imputed, offshore investor will only get a net dividend of 3.7%. So they will expect a capital gain of 11.3%.
By contrast, taxable New Zealand investors get to use Imputation credits issued in New Zealand as a credit against their New Zealand tax return. So the return on the same parcel of shares to a New Zealand based, taxable investor would be 16.3% pa, a 1.3% premium on an equivalent portfolio of international shares.
So based on returns in isolation, there is an argument for taxable Investors to hold New Zealand shares. But does the same logic apply to Australian shares?
Unfortunately, New Zealand investors are not able to utilise Australian imputation credits to mitigate their New Zealand tax liability. So New Zealand investors cannot expect any tax advantage. In the above example, they would expect a net return of 15%, just like investors from other parts of the world.
We note from Figure 4 that the Australian market has a much higher correlation with the New Zealand market than any other market in the world, a median correlation of 0.5. This suggests that the diversification benefits obtained for New Zealand investors in Australian shares is lower than anywhere else in the world.
There are a number of arguments that explain why the two markets might be moving closer together. First, there are many companies that are now jointly listed on both the New Zealand and Australian stock exchanges. Second, and number of Australian companies have substantial business interests in Australia, and vice versa. And finally, it is arguable that the two economies have many similarities, and tend to sink or swim together in world trade terms.
What about a merger between the NZSE and the ASX
Many pundits have speculated that the stock exchanges of the two countries will merge. And there are obvious advantages to such a move. A wider listing of companies will improve economies of scale, making the exchange more efficient. Also, the improvement in liquidity provided by a combined market will make it easier for companies to raise equity capital, and improve the ability of shareholders to trade.
But the fact that New Zealand and Australian companies may be listed on the same board will not change the merits of investors from one country buying shares of companies listed in the other country. Without allowing Australian to benefit from New Zealand imputation credits, and vice versa, investors from both countries can still expect better returns from companies based in the same tax domicile.
Table 2 highlights that over all but three periods, the Australian market provided lower returns than the world market.
Volatility of Returns
Table 2 sets out data comparing the compound returns and volatility (measured by standard deviation) for the New Zealand, Australian and world equity markets, over a rolling 10 year periods. Also listed are the observed correlations between the New Zealand sharemarket and the World Equity markets, and the Australian Sharemarket respectively. It is worth noting that the correlation between the New Zealand markets and the world markets are typically low. But the figures in the last column of Table 2 highlight a trend toward a higher and increasing correlation between New Zealand and Australian markets. This suggests that the diversification benefits derived from Australia are less that the broad markets, and that those benefits are reducing over time.
Annualised Return and Risk Comparison – NZSE 40 Gross Index ($NZ)
10 Year periods Ending 1981 through 1999
Furthermore, the correlation coefficient between the NZSE 40 Gross Index and the MSCI World Index for the 10 years to 31/12/1999 was 0.35. The statistical inference is that the return volatility of the world markets only explained 12% of return volatility of the New Zealand market over this period (the squared correlation coefficient). By contrast, around 50% of the volatility of the local market is explained by volatility of the Australian market.
The trade-off between risk and return is demonstrated graphically in Figure 5 and Figure 6. These charts show risk on the horizontal axis, measured by the annualised standard deviation of quarterly returns, and return on the vertical axis, measured by annualised compound return over each respective 10 year period. We plot a range of portfolio mixes between 0% NZ Shares and 100% offshore and 100% Australian shares.
In Figure 5, we plot results from the period 1980-1989. In Figure 6, the chart is repeated from the period from 1990 to 1999.
All other things being equal, investors will prefer to achieve higher returns for a given level of risk. So the best place to be is in the top (high return) left (low risk) hand corner.
Figure 5 – Risk/Return Profile 1980-1989
Figure 6 – Risk/Return Profile 1990-1999
The two charts clearly demonstrate that investors who have a global perspective generally achieve higher returns, for a comparable level of risk, than investors who limit their international exposure to Australia.
For most investors the question of how to handle their foreign currency exposure causes considerable angst. Investors often get bogged down considering questions about the future direction of currency movement. And may delay the funding of an investment programme because they are concerned about currency.
It is appropriate for investors to consider currency. Nobody likes the short term losses that can arise from rapid and powerful currency movements. But at the same time investment decisions need to be made in the light of the investors objectives, a coherent strategy and be based upon a sound understanding of what is and what is not predictable.
Are currency movements predictable?
First we need to examine the ability of investors to profit consistently from currency movements. A recent Russell Research Commentary examined this topic in detail. The authors concluded that currency markets are prone to inefficiencies that arise from the fact that some investors are not primarily motivated by profit (e.g. central banks, tourists and corporate treasury departments). The study also found evidence supporting some simple trading rules. Hence the proposition that investors can profit from active currency management is plausible.
However, the authors also uncovered many implementation and operational issues that present a significant hurdle to investors. Currency management is complex and requires a deep understanding of the interaction between interest rates and currency movements, and in the pricing and operation of derivatives. In general, these skills can only be found with professional money managers.
Therefore, most investors should employ managers to perform any active currency management. The question of what benchmarks to set and how to derive an investment strategy should be based on the assumption that currency markets are, by and large, efficient. And there is no point in trying to time the implementation of an investment strategy, to take advantage of future currency movements - they are too unpredictable.
Risk and return arguments
All investors are different. So there is no way to provide a “one size fits all” solution. Key differences that will arise are:
the incidence of future liabilities; and
But we can examine two asset classes, offshore bonds and offshore shares, to get a feel for the best generic strategies.
Investors are not obliged to accept currency risk in respect of any asset, either domestic or offshore. The existence of a deep and liquid market in forward currency contracts means that it is quite feasible to hedge exposures back to the New Zealand dollar, even when the assets are spread throughout many countries. Given this, the question for investors is not so much, “should I invest offshore? As it is “How much of my offshore exposure should be hedged?”.
Figures 7 to 10 display the trade off between hedged and unhedged returns for both global bonds and global shares over four different time periods. Each chart shows returns (measured by compound annual returns) and risk (measured by the annualised standard deviation of quarterly returns) over three years.
We observe a marked contrast between offshore shares and offshore bonds.
In three of the four periods examined here hedged bonds provided higher returns than unhedged bonds. But the differences in hedged and unhedged returns are not great enough for us to conclude that returns from hedged bonds are systematically higher than unhedged. Note, however, that the riskiness of hedged bonds is substantially less than that of unhedged bonds for each period. The differences are large enough for us to conclude that hedged bonds are less risky than unhedged bonds.
We can reason this through when we think about the nature of bonds. They are naturally a low risk, low return asset. Their purpose, in a portfolio context, is to diversify and reduce risk. But we know that currencies are volatile and hard to predict. Currency movements may transform bonds into a high risk asset, without improving returns. This suggests that New Zealand investors should have a natural preference for bonds where the currency is predominantly hedged to New Zealand dollars.
Historical data tells us less about the behaviour of international shares. Just as is the case with bonds, we cannot conclude that the returns from shares that are hedged to New Zealand dollars are systematically greater or less than the returns from unhedged shares. We also cannot draw any conclusions about comparative risk. Sometimes hedged shares are more volatile than unhedged. Sometimes they are not. And there is not enough evidence to suggest that there is any systematic difference in the riskiness of hedged shares compared with unhedged shares.
The rational explanation of this is that shares are a high risk asset. Therefore, rational investors will only invest in them if they can expect higher returns. The additional risk imposed by foreign currency exposure is relatively small. We can also argue that corporations often have a natural hedge in that their profits are often derived from investments in many different countries. So the imposition of adjustments through derivatives is less effective.
Perhaps the most powerful illustration of this point is provided by Figure 11. This chart captures the behaviour of assets over a long time. In this case, twelve years. We can see that hedging makes a difference to the riskiness of bonds, but the effect of hedging upon shares is not material.
So what should investors do?
Many investors experience some angst in the face of strong currency movement. About half of them will be nervous about their investment because they think the NZ dollar is going to bound back at any moment (devaluing their offshore investment). The other half is thinking that the NZ dollar will continue to spiral, and they just want to get the whole lot offshore. And there is no way of predicting which group is right, or whether they are both wrong.
In fact, the future direction of currency is never certain. If it ever was, then the markets would react quickly to close the gap, and the price would adjust. That is largely how markets work. So what should investors do?
The case for hedging international bonds is very compelling. All the evidence examined by Russell suggests international bonds should be predominantly hedged.
The case for hedging international shares is less clear. Long term investors should not be sensitive to currency. But that will be cold comfort if they are unhedged and the NZ dollar has soared, or as is more likely in recent experience, they are hedged when the NZ dollar has plunged.
Figure 12 - Annual returns to 31 August 2000
From Figure 12 we observe that the returns of the hedged and unhedged World Share index to August of each year since 1994. In the year to August 2000, unhedged investors were happy. But in the year to August 1999 it was the hedged investors who got more. And in the year to August 1998 hedged investors got much higher returns. All of this reinforces the point that currency movements are unpredictable.
There is another option to help calm short-term nerves. This is for investor to literally hedge their bets, as shown in the third column of Figure 12. With a 50% hedge the investor will not ever experience the major highs of an unhedged portfolio, but they also will not be subject to the worst of the lows.
This conclusion is reinforced by an earlier Russell Research commentary that discussed the “Regret Syndrome”. Investors experience regret when the hedging strategy that they pursue differs from the market norm, and underperforms the market norm for some period. For example, investors who have predominantly hedged over the last year will be experiencing regret because their strategy has done less well than that of other investors that are unhedged. Regret is different from risk in that when we talk about risk it is forward-looking. Regret is always retrospective.
Gardner and Thierry attempted to quantify regret, and came up with measures of expected regret. That is, we know that investors will not be happy at some point in the future. What Gardner and Thierry did is propose a framework to calculate how often they will be unhappy, and ho unhappy they will be. The authors note that although regret refers to an emotional response to investment it is still a genuine consideration because regret may be detrimental to future decision making.
They conclude that the best strategy for minimising regret is to impose a 50% hedge. Minimising regret will always be secondary to maximising portfolio efficiency. But in the absence of a clear efficiency argument, investors can consider secondary goals such as minimising regret.
We conclude that all investors, especially New Zealand based investors, need to place a significant proportion of their assets offshore. However, it is critical that offshore investment be globally diversified. Simply spreading investment to Australia is not sufficient to capture the full benefits of global diversification.
The management of currency needs to be considered independently of the decision to invest offshore. This is because hedging strategies have the potential to allow offshore investment without necessarily changing the currency base. An analysis of historical evidence reveals that a hedged exposure to international bonds generally yields the same return as an unhedged exposure. But in the case of shares there is no real argument one way or the other. In the absence an efficiency argument, we believe there is room for secondary considerations, such as minimising regret. Once all of those things are considered a 50% hedge on international shares is a good option.