What we believe about investments

Index Funds: An Introduction to Asset Class Investing

We offer asset class investing throughout New Zealand in Christchurch (chch), Auckland, Wellington, Dunedin, Nelson and the Otago and Canterbury regions.

At its heart, asset class investing is an evidence based investment solution built on several key beliefs, each backed by considerable evidence.

Asset Class Investing is a method that uses a wide range of passively managed funds (e.g. index funds) to construct a portfolio that meets your specific needs while maximising your return, based on the volatility you allow in your portfolio. In other words, owning index funds alone or any single good investment is not enough. You must own the right mix of investments for your specific circumstances.

The issue can be put simply. Not all asset classes have the same risk-reward characteristics; some are high risk, some are low risk. Some zig while others zag. Investing in a variety of asset classes in appropriate quantities yields greater benefits than owning just a few. So Asset Class Investing allows you to turn tools (such as specific index funds or passively managed funds) into an appropriate, well-rounded portfolio of investments that are specific to your circumstances. This is merely an introduction. We hope it provides you enough detail to be interesting but leaves you asking more specific questions, which – of course – we will be happy to answer.

In this article we briefly summarise what we believe about investment management and why we use an ‘asset class investing’ approach. Click on any of the links below to be taken directly to that section.

1. Investment return is payment for taking investment

To manage our portfolios properly, Bradley Nuttall is concerned with two fundamental concepts:

  1. Risk – This is the uncertainty of future returns and is often measured by standard deviation. For example, if you own a high risk portfolio, it will go up fast in good markets and down fast in bad markets. In other words, over the short term the portfolio’s value is very volatile (hence the reason risk is sometimes called volatility). If you own a low risk portfolio, the opposite is true. Your portfolio’s value goes up at a steadier but slower pace, and is more insulated from downward movements.
  2. Return – This is ultimately the compound rate of growth in your portfolio. Given enough time, a high risk portfolio will likely earn higher returns than a low risk portfolio.

Risk and return must be considered together. Although most investors want high returns and low risks, in the long run this trade-off is not achievable. The fastest way to identify an investment charlatan is to listen for them offering high returns with low risks.

The chart below shows the risks and returns of the NZX 50 from 1991 – 2014 Return is on the vertical axis (about 9%) and risk is on the horizontal axis (about 16%).


There are two questions that arise from this:

1. How do you reduce risk without sacrificing return?

Answer: Diversification

2. How do you increase return without increasing risk?

Answer: Intelligent risk exposure

2. Investors should diversify their risk exposure

Diversification reduces the risk (or volatility) compared to non-diversified portfolios. Risk is the source of investment returns, and the most robust portfolios are constructed of different types of risk. The risks facing the New Zealand economy are different to those facing the European bond market and are different again to the risks of Canadian shares. Bradley Nuttall selects investments that increase diversification and lower overall investment risk to our clients.

The essence of good asset allocation is assembling large numbers of investments that (to the greatest extent possible) diversify risk.

Bradley Nuttall portfolios include over 7,000 underlying securities from:

  • 24 developed economies, such as Canada, Singapore, Switzerland and Australia
  • 17 emerging economies, such as China, India, Brazil and South Korea
  • All global business sectors across over 400 industries, from healthcare to manufacturing and commodities to financial

The New Zealand share market represents less than 0.05% of the value of the world’s share markets. Visually, if each country’s size represented their contribution to global share markets, New Zealand would be represented by the dot next to the green arrow.

World Market Capitalisation

So where’s the evidence that diversification reduces volatility?

As mentioned above, all investments can be analysed by looking at risk and return. If we look at any one share in the NZX 50 (the index of the top 50 companies on the New Zealand share market) we find it has about the same expected return as the NZX 50 but about double the volatility.

Below is a very important graph, showing return on the vertical axis and risk on the horizontal axis, and based on returns from 1991 – June 2015.

Risk and return of the NZX 50 and one NZX share 1991 – June 2015

Why would an investor accept more risk for the same return? Most shouldn’t – it wouldn’t make sense. However, some do, primarily because risk has an upside and a downside and they are gambling on a big upside. Our investors don’t gamble. We’ll take the lower risk option.

Below we show a third portfolio option – 50% cash and 50% NZX 50. Note that this portfolio is even lower risk than (to the left of) the NZX 50 equity portfolio. This makes sense; this portfolio also has a lower return. So, investors wanting to reduce their risk using cash can do so, but at the cost of lower return.

Risk and return of the NZX 50, one NZX share and a 50% cash/50% NZX portfolio 1991 – June 2015

However, by using the tools of diversification and risk management more intelligently, Bradley Nuttall can both increase returns and decrease risk relative to the 50% cash and 50% NZX 50 portfolio.

The chart below shows the risk and return of a range of simulated Bradley Nuttall (BNL) portfolios over 24+ years from 1991 – June 2015, compared to an index that represents the returns of the New Zealand stock market (NZX 50) over the same period. Note, BNL portfolio returns are shown net of management fees but gross of adviser and custodial fees. The NZX 50 index has no fee.

Risk and Return of the NZX 50, one NZX share, a 50% cash/50% portfolio and BNL portfolios 1991 – June 2015

As the scatter plot above shows, higher risk portfolios (as shown on the horizontal axis) lead to higher returns (as shown on the vertical axis). By diversifying portfolios, we are able to provide similar returns to the NZX 50, but at significantly lower risk. This is due to intelligent diversification.

3. Investors should only take the risks that pay

While we have asserted that risk is the source of return, not all risks pay the same. Thanks to the work of economists Eugene Fama and Kenneth French, we now understand that four risk factors explain about 90 to 95% of long term investment portfolio returns. These risk factors are the basis on which good asset allocation decisions should be made. The risks are:

1. Market risk
This is the risk of capitalism that affects all businesses, including political stability, interest rates, credit availability, etc. In other words, market risk is not business specific risk, but the risk of ‘business winning’. Market risk cannot be diversified, and thus, investors are compensated for holding it. This conclusion helped Bill Sharpe win a Nobel Prize in 1990.

2. Size risk
This is the risk associated with small businesses. Small businesses must pay potential investors higher rates of return, because they are more likely to fail. However, because these businesses are small, they have greater upside if they succeed. We measure size risk using market capitalisation, which is the total value of the company’s shares.

3. Value risk
This is the risk associated with businesses that appear to have poorer prospects, or are out of favour with investors. To raise capital, these out of favour businesses must offer investors higher returns because investors are not convinced about their long term profitability. However, since these businesses are out of favour, they have greater upside if they turn their businesses around. Value risk is measured using book-to-market ratio (BtM). The BtM tells us the ratio of the company’s accounting value to the market value of the business (its market capitalisation). Out of favour firms with high BtMs are termed “value” and firms with market valuations well in excess of their book valuations are termed “growth”.

4. Profitability risk
This is the risk associated with businesses that are more profitable than peers when controlling for book value. This is because there is some risk or uncertainty associated with their profits. There may be several reasons for this, anticipated new competition, perceived maturity of the firms market offering, anticipation regarding cyclical earnings, pending liability, etc. Due to this risk or uncertainty, shares of high profitability companies bear higher expected returns than the shares of low profitability companies with similar book values.

In summary, the greater a portfolio’s exposure to market, size, value and profitability risk factors, the higher its expected returns.

The chart below illustrates two of these risk factors. The total market is the intersection between small and large shares, and growth and value shares.

Cross section of investment risk factors

As shown below, the greater a portfolio’s weighting to small and value risk factors, the higher its expected returns.

The evidence for the higher expected returns of value and growth companies was presented in a paper published by Eugene Fama and Kenneth French in the Journal of Finance 1992, called “The Cross-Section of Expected Stock Returns”, and in another paper, “Value versus Growth: The International Evidence”, published in the Journal of Finance 1998. Subsequent evidence has been found in both New Zealand (“New Zealand mutual funds: measuring performance and persistence in performance”) and Australia (“Size and book to market effects in Australian share markets: a time series analysis”). For profitability the most comprehensive study is “The other side of Value: Good Growth and the Gross Profitability Premium”).

The differences in returns can be easily seen by viewing the annualised compound returns for small companies, value companies, all companies (total market) and growth companies in US, international and emerging economies as shown below.

Evidence of premiums for owning small and value firms

There is evidence that risk exposure pays-off in New Zealand shares as well. The NZX Portfolio Index has a maximum weight in and one company of 5% whereas the NZX 50 has no cap. The result is that the NZX 50 has much larger exposure to large companies (for example over 10% of the index was in Fletcher Building as of 2015). The Portfolio Index has greater exposure to smaller companies. Give what we’ve seen elsewhere in the world we’d expect the Portfolio Index to have higher returns since inception and that’s exactly what we observe looking at the data.


4. Low cost investments do better than high cost investments

Low cost investments do better in the long term than high cost investments. This is the finding of nearly every academic study on the subject, with one of the most recent being done by Morningstar.

The Morningstar Director of Fund Research, Russell Kinnel, observed:

That sounds fairly conclusive. Perhaps everything you need to know about managed funds is contained on this napkin…

Below you see a comparison of managed fund costs between the average managed fund and funds used by Bradley Nuttall.

Comparison of BNL Balanced Portfolio Investment Management Fees vs average New Zealand Allocation Fund Investment Management Fee.

Nobel Prize winner in financial economics, Bill Sharpe, put it this way:

5. Investors should never speculate

A speculative investment is one in which a winner must be offset by a loser. For example, in a casino, when a poker player wins a hand, the winner merely ‘wins’ what others have ‘lost’. And inevitably, the casino takes a small cut for arranging the game. The same is true with investment speculators. They try to beat the market by selecting winning securities, or market timing. The funny thing is this: in order to get out of the market (time the market), someone must get in. In order to buy a great investment, someone must sell it. There are always two sides of the transaction and in this game, if one wins, the other loses. All sides pay (the casino) to trade, but only one side in any trade will win in any one transaction. In other words, it’s a zero-sum game (after considering the market return), minus costs.

In a landmark study of 91 major corporate pension plans, over a ten year period which included both good and bad markets, the authors found that 94% of investment performance was explained by asset class selection, 2% by market timing and 4% by security selection.

Study: Determinants of portfolio performance

Even though security selection and market timing explained 6% of the variability of returns, the overall contribution to performance was negative. The average plan lost:

– 0.66% per year from market timing decisions
– 0.36% per year from security selection

They would clearly have been better just sticking to asset allocation.
Gary P. Brinson

Investment selection

Consistent with the principles of asset class investing, we first define the asset classes that we consider prudent for investments and then select appropriate investments for each, using the following criteria:

  • Fees and expenses
  • Diversification among securities within the asset class
  • Quality of execution (low trading costs and light market impact of trading)
  • Consistency of risk exposure
  • Investment style and philosophy, i.e. compatibility with asset class philosophy
  • Underlying investment process
  • Tax efficiency
  • Liquidity, i.e. the ability to realise capital at short notice
  • Manager diversification

In nearly every case, the most appropriate investment is a clear combination of the above features. All selected investments are monitored quarterly to ensure they perform as expected and take investment risks consistent with the asset class they were selected to represent.

Portfolio construction

We’ve already quoted a study that showed that 94% of investment performance is explained by asset allocation. Roger Ibbotson, of Yale University, writes “[we] can extrapolate from the study that for the long term individual who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100% of performance” . Another academic study asserts that asset allocation alone accounts for 100% of a portfolio’s total return, on average .

It is easy to see, then, why we believe asset allocation and portfolio design is paramount.

Intelligent portfolio design allows Bradley Nuttall to simultaneously reduce investors’ risk and increase their expected return relative to holding any one individual investment.

When constructing portfolios there are three distinct decision layers, with the first layer having the most impact on the ultimate risk and return:

  •  Debt/equity decision
    How much debt (for example, bonds and fixed interest) vs how much equity (for example, shares and property) should you own? This has the largest impact on your ultimate risk and return.
  •  The market decision
    Which markets (domestic, international and emerging) will you invest your money in? This decision vastly increases diversification to lower the risks of holding investments.
  •  The risk factor decision
    Within a specific equity market what is your exposure to small cap shares (small), large cap shares (large) and inexpensive shares (value), and what is your exposure to loan length (term) and to creditworthy borrowers (quality) on the debt side? This decision can increase expected return of the overall portfolio.

Defining Asset Classes

So, which markets and asset classes should we invest in? Ultimately, we want to invest in nearly all markets and hold most asset classes (subject to our previously explained investment selection requirements). Why? The chart below helps explain – it includes all the asset classes we use in our portfolios. The second chart ranks the returns from highest to lowest each year. As you can see, there is no pattern, and paying anyone to guess or speculate on a pattern means you may very well miss out on the returns available through a diversified approach.

Asset Class Returns - randomness of returns


As can be seen below, Bradley Nuttall blends the available asset classes to create portfolios. For example, the 20/80 portfolio contains 20% exposure to shares and 80% exposure to fixed income (divided between New Zealand, Australian and international shares). The 90/10 portfolio contains 90% exposure to shares and 10% exposure to fixed income.

Broad asset class allocation of BNL portfolios

In blending these asset classes, we create portfolios with distinct risk and return characteristics. The chart below shows that investment return (measured on the vertical axis) increases as each portfolio takes more risk (measured on the horizontal axis). This allows us to provide portfolios that match investors’ unique risk and return needs.

In summary, asset class investing is a methodology where tools such as Index Funds or passively managed funds are used in specific combinations. It employes the debt equity decision, the market decision, and the risk factor decision to tailor an investment portfolio for our clients that improves their return and customises the overall volatility, to an amount that is both acceptable and appropriate for them.

If you would like to know more about how we could help you with your investment portfolio leave your details with us and we will contact you:

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[1] Ibbotson, R.G., (2000) The True Impact of Asset Allocation on Returns, Ibbotson Associates.

[1] Surz, R., Stevens, D., and Wimer, M., (1999) Investment Policy Explains All, Journal of Performance Measurement, Summer 1999, p 43-47.