The September quarter was a mixed period for equity investors as the NZX appreciated by 0.6 per cent in capital terms and 2.2 per cent in gross terms. This compares favourably with the Australian market, in Australian dollar terms, and the MSCI Index as measured in US dollars.

It is important to point out the differences between the capital and gross indices in the accompanying table.

Most of the world’s high-profile indices – Dow Jones Industrial Average, S&P 500, Nasdaq Composite, FTSE 100, Hang Seng etc – are capital indices that do not take into account dividends received. The NZX50 Gross Index is an unusual benchmark index as it takes into account all dividends paid and assumes that these dividends are reinvested.

The NZX50 Gross Index’s performance is often compared with capital indices.

This is inappropriate because a gross index will always outperform a capital index and the superior returns of a gross index are amplified over the longer term.

Former NZX CEO Mark Weldon established the NZX50 Gross Index as the exchange’s benchmark gauge, to replace the NZX50 Capital Index, on March 3, 2003. He did this because the NZX 50 Capital Index was only 1881 at the time – still 52.6 per cent below its all-time high on September 18, 1987 – and there were continual media reminders of the NZX’s poor performance since the ’87 crash.

The new gross index has had its desired result as the media is now able to report that the NZX50 Gross Index regularly achieves an all-time high, as all gross indices should on a reasonably consistent basis.

At the end of September the benchmark gross index stood at 5255, a 179 per cent increase since its 2003 inauguration day. Meanwhile, the relegated capital index has risen by only 47 per cent over the same period and is still 30 per cent below its 1987 peak.

There is nothing wrong with gross indices, particularly as all investment managers measure their performance against gross, rather than capital indices.

In addition, gross indices are probably more appropriate for New Zealand because we have high dividend yields and a large percentage of our dividends are imputed with the full dividend available for reinvestment.

However, we should be careful about using gross indices because not all investors, particularly individuals, reinvest their dividends. It is particularly difficult for investors to outperform a gross index in a rising market because a dividend is considered to be reinvested, from an index measurement point of view, when a share price goes ex dividend whereas investors cannot physically reinvest these dividends until they are received a few weeks later.

Thus it is extremely difficult for investors who don’t reinvest their dividends, or don’t reinvest them immediately, to achieve the same result as a gross index over time.

The gross index methodology also makes it difficult for passively managed funds to match the performances of gross indices and Smartshares is a good example of this. SmartMIDZ, which aims to match the return of the NZX MidCap Capital Index, has delivered a return of 11.3 per cent a year over the past five years compared with 7.0 per cent a year by the NZX MidCap Capital Index and 12.4 per cent a year by the NZX MidCap Gross Index.

The accompanying table shows that over a 10-year period the NZX has delivered limited capital growth, especially compared with the ASX and MSCI World Index. However, on a gross basis the NZX has performed relatively well because the NZX has a large number of low growth, high dividend yield companies.

This is one of the reasons why KiwiSaver is such an excellent investment scheme because all dividends are reinvested, a high proportion of NZ-based companies pay fully imputed dividends and New Zealand equity investments are not subject to a capital gains tax.

Given this, it is an absolute shame that so many KiwiSaver investors are in low returning conservative funds. The poor performance of these low-risk funds is amplified over the longer term because interest income cannot be fully invested as it is subject to tax. Capital gains on fixed interest securities are also taxed whereas capital profits on domestic equities are not subject to tax.

It is unfortunate that many commentators restrict their analysis to KiwiSaver fees when tax considerations can have a much bigger impact on the performance of these funds.

Meanwhile, the NZX had a large number of ups and downs in the September 2014 year. The December and June quarters were only slightly positive on a gross basis whereas the March quarter appreciated 8.5 per cent and the September quarter was up 2.2 per cent.

One of the more interesting aspects of the past 12 months is that the NZX was relatively uncorrelated with the ASX and the MSCI Index. The March quarter was the best period for the the NZX while the December quarter was the ASX’s best period and the MSCI Index performed better in the December and June quarters.

The last three months were relatively subdued for all three indices but there were a few ups and downs within the three-month period. The ASX appreciated 4.4 per cent, on a gross basis, in July while the NZX was up only 0.5 per cent and the ASX plunged 5.4 per cent in September while the NZX had a positive 0.6 per cent return.

There was also a great deal of volatility among individual companies, particularly Diligent Board Member Services in New Zealand.

Diligent was the second best performer in the September quarter but the second worst in the September year.

The best performing NZX50 Index companies in the September year were Pacific Edge, Meridian Energy, Fisher & Paykel Healthcare, Air New Zealand and Metlifecare.

The worst performing were Chorus, Diligent, Trade Me, A2 and The Warehouse.

The other big issue over the past three-month and 12-month period has been the performance of the NZ dollar, particularly against the US dollar. It started the September 2014 year at 82.99 US cents. At the end of December it was 82.0 cents, the end of March 86.64 cents, at June month end 87.76 cents and 77.67 cents at the end of September.

New Zealand investors will have benefited from the depreciation of the kiwi dollar over the past 12 months and the positive 12.2 per cent MSCI World Gross Index return, in US dollar terms, translates into nearly 20 per cent in New Zealand dollars.

The outlook for the next three and 12-month periods will depend on a number of factors including economic activity, market valuations, company earnings, liquidity and, as far as New Zealand is concerned, commodity prices and the dollar.

Economic activity is picking up in the US but Europe remains subdued and China is slowing. Thus the global economic recovery remains in place but it is fairly muted.

Sharemarket valuations are high while earnings growth is positive but mostly below 10 per cent on average. The world is awash with liquidity as investors, both private and professional, hold large amounts of cash. This is a positive catalyst, particularly if company earnings pick up.

The focus in New Zealand will be on dairy prices, economic activity and the currency.

The sharp drop in dairy prices is a major concern although there has been some compensation from the lower dollar. Unless dairy prices pick up sharply in the short-term then any NZX market gains in the current quarter will be due to stock selection rather than an overall market rise.

Brian Gaynor

Portfolio Manager

Disclosure of interests: Milford Asset Management holds shares in many of the companies listed above on behalf of clients.