One free lunch - diversification

05/07/2013

We've talked about volatility before. It's the rate at which the price of an investment moves up or down. Returns from assets like shares and property fluctuate more widely from year to year than returns from assets like bonds and cash. By investing in some of each, you can reduce the volatility of your overall portfolio without lowering your expected return. It's called asset diversification. And it's often talked about as the "only free lunch" in investing.

In addition, different assets perform differently in different market conditions. Cash investments, for example, might produce solid returns at a time when shares are in the doldrums – and vice versa. For example, in the last scheme year , income assets (like cash and fixed interest) outperformed growth assets (like property and shares). The previous scheme year, the opposite was true.

Investment options

As you know, you have a choice of four different portfolios in which to invest your savings – Growth, Balanced, Stable and Cash Plus. Each invests in a different mix of asset classes to suit different levels of risk tolerance (the level of volatility you're comfortable with), investment goals (the return you expect) and investment timeframe (how long you have to invest).

The Growth option is expected to produce the highest returns over time with the most marked fluctuations from month to month. At the other end of the spectrum, the Cash Plus option is expected to produce the lowest but most consistent returns.

The trustees have set a benchmark mix of asset classes for each option (set out in the Statement of Investment Policies and Objectives or SIPO ). Over time, the asset classes will move above (called 'overweight') or below ('underweight') the benchmark proportion of the scheme. This is generally the result of varying investment returns for each asset class as well as the impact of new contributions, benefit payments and members switching from one option to another (e.g. from Growth to Balanced). As a result, rebalancing the asset classes within the stated range is an ongoing process.

Asset classes

Let's take a look at the different asset classes your scheme invests in.

Income assets

The return on these assets comes mainly from income (e.g. dividend and interest payments)

Fixed interest

These investments offer a fixed income for an agreed period of time. They include government bonds, bank bills and company debentures. They can be bought and sold before the fixed period of time is up. If general interest rates fall, then the capital value of the investment increases and your fixed interest investment is worth more. On the other hand, if interest rates rise, the capital value falls and the investment is worth less.

Cash

These are fixed term investments made for very short terms – usually less than 12 months. 'Cash' doesn't necessarily mean money deposited in an interest bearing bank account. It can include short term fixed interest investments including floating rate notes and bank bills.

Growth assets

The return on these assets comes mainly from changes in price. (Although they may also provide a source of income in the form of dividends and rent)

Shares

Shares (also called stocks or equities) represent a portion or share in the ownership of a particular company. We invest in Trans-Tasman shares (company shares listed and traded on the New Zealand and Australian stock exchanges) and global shares (company shares traded on stock exchanges in other developed and emerging market countries like the USA and India).

Property

Investments in (mainly commercial) land and buildings. This can be done direct (by buying a particular property) or indirectly by buying units in a trust that owns a number of properties.

Commodities

Commodities are tradable items that, generally, can be processed further and sold. They include energy and industrial and agricultural goods. Examples include gold, electricity and – a commodity hugely important to New Zealand's economy – milk.

Infrastructure

Infrastructure includes the basic services and facilities needed for an economy to function. Examples include roads, bridges, sewers, electricity networks and telecommunications.

Fund of hedge funds

Hedge funds pool money from investors and reinvest it in a range of often highly complex investments. While they sometimes invest in traditional assets like shares and bonds, they are best known for investing in other very sophisticated investment vehicles. As privately-owned companies, they are not subject to the same financial regulation as other investment funds and so they can invest in a wider range of securities. The owner or manager is paid a percentage of the money he or she makes and a percentage of the money under management.

A fund of hedge funds is one that invests in a number of separate hedge funds to diversify overall hedge fund risk.

* Year to 30 June 2012.
** There's a fifth option too – Super Steps – where your savings are invested automatically in one, or a combination, of the Growth, Balanced and Stable options depending on your age.
***The SIPO sets out the trustees' expectations for everyone involved in managing the scheme's investments. It includes investment objectives, strategy and limits as well as criteria for measuring investment performance. You'll find the SIPO on the website under 'Documents and forms'.

Jargon buster

Here are explanations of some of the investment terms used in this story.

Bank bill

A bank bill is a short term investment (generally between 30 and 180 days). The investment has a 'face value' which is the amount the investor will receive at the maturity date. The investor buys the bank bill at a discount to its face value. The return is the difference between the face value and the purchase price.

Floating rate notes

A bond with a variable interest rate. The interest rate payable is reviewed at a set frequency (say, every three months) using an agreed formula.

Debenture

A type of unsecured loan made to a company. The loan is backed by the general credit-worthiness of the company rather than being secured against any particular asset.

Dividend

An amount paid to shareholders from a company's profits.

Security

A security is a financial instrument with some type of financial value. There are two main types of securities:

· Debt securities – money that is borrowed and must be repaid (e.g. a government or company bond), and

· Shares – representing part ownership in a company.

 

This website is provided by Mercer (N.Z) Limited on behalf of the trustee of the Police Superannuation Scheme (PSS). The trustee pays a fee for the provision of this service, however this fee is not conditional on you using this service or acting on the information or advice provided through this service.

PSS Trustees Limited is the issuer of the Police Superannuation Scheme (PSS). A copy of the PSS product disclosure statement is available under Documents and forms and at companiesoffice.govt.nz/disclose.