By investing in the companies listed in the world’s largest share and bond indexes, for example the S&P 500, it’s pretty simple to construct a global portfolio with thousands of different investments.

But that doesn’t necessarily mean you have all the benefits of diversification, because correlation between bond and share price movements can be high at times.

There are other asset classes not correlated to shares or bonds, or only very loosely. And these asset classes are well established and understood, with billions invested in them overseas. However, we don’t seem to do the same in New Zealand. A recent report by the Centre for Sustainable Finance highlighted that in Australia 18 per cent of superannuation funds are invested in private assets. In New Zealand, only 2 per cent are. So, what are these asset classes that can help increase diversification?

The first and obvious category for investment is Venture Capital, which is less about interest rates and market movements, and more about the founders of promising startups and their ability to deliver success. The second is Private Equity, for the same reasons – albeit via more established private companies which have already proven their potential.

More options

A third is investing in mortgages. If loaned conservatively, their value isn’t significantly affected when interest rates change. A fourth investment option is physical property. If there’s only modest leverage in these property investments, they can also display more resilience to interest rate changes.

A fifth option is physical commodities, which often don’t correlate with interest rates, depending on the product. Some commodities, like gold, are specifically bought as a store of value and for their traditionally uncorrelated characteristics. And sixth is more esoteric investments like crypto currencies, which were created to differ from other investments, and behave as such.

So, do KiwiSaver managers have much invested in these asset classes? In a word, no. Why is that? To my mind, there are several excuses.

The first is a lack of liquidity for account withdrawals and/or switches. This argument says that because KiwiSaver investors can switch managers at any time, or withdraw all their money after 65, it’s necessary for all investments to be instantly sellable, aka highly liquid. But if properly managed, it’s unlikely that enough investors will switch or redeem KiwiSaver funds to cause a liquidity problem for the manager or be inequitable for the investors that remain.

Fees and assets

The second excuse is that regulators don’t like illiquid investments in KiwiSaver, because the fees could be unreasonable and the assets hard to sell. This is simply not true. Regulators don’t like too much invested in illiquid investments, and their job is to ensure fairness and equity for all investors. But that doesn’t mean they don’t allow careful investing in private assets. Regulators understand that, if done well, investment in private assets can dampen volatility and enhance returns. It’s why some KiwiSaver managers are already investing this way.

For managers to say they are concerned fees will seem “unreasonable” is to assume a) that it costs more to manage private assets and that b) their fees were reasonable to start with. Both are dubious assertions, in my opinion.

The third excuse is with illiquid assets not being priced daily, it’s hard to have them in an investment scheme where investors can move their money any time they wish. That certainly makes holding and valuing illiquid assets harder but shouldn’t put them into the too-hard basket. The KiwiSaver industry, and its supervisors, now have plenty of experience in valuing alternative assets.

The real reason

Despite all these excuses, to my mind the only real reason managers don’t invest much in alternative and illiquid assets is that it’s simply harder to invest this way and can be more expensive. Many KiwiSaver managers don’t like hard, especially if they can rely on the power of their franchise more than the investment returns; banks being an obvious example. And as KiwiSaver fees are likely to be over $700 million in total this year, they should be willing to pay any manager of illiquid assets what it takes to get investment returns relatively higher.

Instead, fees seem to remain consistent and, in some cases, high, but very few are putting those fees towards the “harder” investments that could help diversify funds further. The sad reality is that alternative investments, which could enhance returns and dampen volatility, are not de-rigueur for KiwiSaver managers. It seems that the status quo might just be too easy, and too profitable.

It shouldn’t be that way and isn’t overseas. But from what I can see, it is here.