Category Archives: Inflation

Guaranteed returns or guaranteed losses?

It seems trite to be talking about investment returns in the context of the “feesmustfall” campaign however, there are people who still need to invest and grow their money and in some ways life goes on.

One of the more frequent conversations we are currently having is around the issue of market volatility – which to some investors is apparently a new thing. It is in this context (and on the back of 7-8 years of really good returns) that investors often lose sight of the big picture. Market volatility causes panic and they start talking about not wanting to take any risk on their investments. Inevitably their focus turns to issue of “guaranteed” returns.

One such example is of an investor who is looking for income and has decided that the best way to secure his income is by way of a 5 year term certain annuity. In short he will receive an escalating income for 5 years and is guaranteed to receive his full capital in 5 years time. He is over the moon…but should not be.

His income may be secure but he is also guaranteeing himself a capital loss. What he is failing to take into account is that while he may receive his capital back (in nominal terms) in 5 years, in real terms he will be poorer by ±26% – or in his case, R1m on R3.8 million. This is because he has failed to factor in inflation risk! He has forgone volatility risk in favour of a much more dangerous and insidious risk in the form of inflation.

Volatility is a short term investment risk and is just one form of investment risk. Exposing your investments to this kind of risk is the only way to deal with inflation risk. But it requires time to work…1, 3 or even 12 months is not “time”. It takes years…

Inflation risk, on the other hand, is a long term investment risk and if you don’t take enough volatility risk you are guaranteeing that you will lose money. Don’t be short sighted – the current market volatility is nothing new – it has happened before and will happen again. Don’t panic and don’t lose sight of your plan. Sit it out and you will reap the rewards…or you can panic and buy yourself a guaranteed capital loss!

Risk free returns?

I recently saw an advert for RSA Retail Bonds that was advertising “risk-free” returns. This kind of thing really gets up my nose and in my opinion it smacks of false advertising…RSA Retail Bonds are not the only culprits – just about all of the banks do it too.  “No fees or commissions” or “Risk-free”.

Let’s get this straight – there is no such thing as a risk-free investment. The reason they are advertised as “risk-free” is because they are only ever referring to one kind of risk; that of volatility! These “investments” never refer to inflation risk and they also assume that “default” risk could never apply either!

Broadly speaking there are 2 kinds of risk that really matter to investors: volatility and inflation and they are kind of on the opposite ends of the risk spectrum from one another. Volatility is a short-term risk whereas inflation is a long-term risk.

When things like RSA Retail Bonds claim to have no risk associated with them they are referring to volatility and that is all. They are not claiming to be risk-free, especially when it comes to inflation risk. This is, in my opinion, misleading. You could well invest your money into these kind of investments believing that you are taking no risk at all (because that is what the adverts imply) and then find out that when your investment falls due that you actually have less money (in real terms) than when you started off – all because you did not take enough risk. It’s kind of ironic that in order to counter inflation risk you need to take some volatility risk.

On top of this, any money invested into the RSA bonds is locked in for a minimum of 2 years. The historic returns from these investments have been around 7% pa. By contrast, if you had invested into an “enhanced income” type unit trust fund you would have had returns of ±8-10%* pa for the past few years and would have had access to all of your capital within 48 hours…and all because you took a little bit of (volatility) risk!

So be warned; RSA Retail Bonds are not “risk free” as is claimed. They carry a significant amount of inflation risk, especially after tax.

 

Note:

*typically these funds are designed to generate returns of “cash+2%”pa. This is not guaranteed and there is a small amount of volatility risk that could apply over periods of less than 12 months.

(10) Dumb ways to die (financially)

A year or so ago my kids introduced me to a very cute you tube clip, “Dumb Ways to Die” which was a public service campaign to promote rail safety in Melbourne, Australia. It quickly went viral – you can watch the clip here https://www.youtube.com/watch?v=IJNR2EpS0jw

For some reason I found myself humming the tune while I was on my way to work recently and while I was driving my focus turned to dumb things people do, financially speaking, that is. Without much effort I quickly came up with “(10) Dumb ways to die (financially)”.

Here is the list (which I will explore in greater detail over the next few posts):

  1. Withdraw from your retirement fund when you change jobs.
  2. Withdraw from your preservation fund before retirement.
  3. Fail to contribute to your retirement fund at the maximum level.
  4. Don’t have a (valid) will.
  5. Invest via any insurance based product.
  6. Fail to budget.
  7. Fail to pay off your credit card in full each month.
  8. Fall behind on your tax returns/get on the wrong side of SARS.
  9. Fail to take sufficient equity/volatility risk on your investments.
  10. Buy last year’s winners when investing.

I am sure I could add many more to the list but that’s enough for now.

Look out for the “explanation” of each of them in coming posts and enjoy the song/video clip .

Not even with a very long barge-pole

I was recently asked by the editor of Finweek what I thought of Sanlam’s “new” RA. Here is my response:

“On a level, Sanlam could be applauded for trying to encourage saving for retirement in SA. However, it is my belief that anyone that can offer me a “bonus” or “reward” at some stage in the future (over and above my normal investment return) is either exposing me to more risk than I should be or else is charging me too much upfront. In the case of the new Sanlam RA I believe the latter to be the case. There is no way that the product has been designed to cost Sanlam money or that Sanlam would just pay investors a bonus out of the “goodness of their hearts” – the shareholders would not allow that.

In short there are 2 major problems with the new product:

  • It is too expensive – they claim to have “Unparalleled value for money with among the lowest reductions in yield in the market” and yet their annual marketing and admin fee alone starts @4% pa (on the first R500k and decreases to 3.5% pa on amounts greater than R2m) When reading through a quote from them it is also just about impossible to determine what the total and actual costs will be – it is too opaque and is “typical” insurance company in that respect.
  • It is a contractually based form of saving and when (not if) you need to change your premium or the term (because of stuff out of your control) you are going to pay a penalty – even though they claim that these have been reduced, the actual penalty is a function of the much higher cost that you are paying for the “promise” of a bonus. The following quote is directly from their website “It is not appropriate for clients whose variable incomes will not enable them to keep paying their monthly contributions”  – statistically, that excludes just about everyone in the world!

For my money I would either go with a unit trust RA or an index tracker RA – the recent paper by National Treasury recognises the latter to be the cheapest option in SA at the moment and the returns from this option have surpassed most of the so-called “best managers”.

Keep it simple”

 

Start now!

I had an interesting meeting with a young client recently who was at great pains to tell me that he had managed to get off the company pension fund because they were taking too much money off his salary each month and the fund was far too boring for someone his age. He felt that he could do better with the money and his planned strategy was to go as high risk as he could for the next 5 years. Perhaps he would make a lot of money and perhaps he would lose it all…either way it did not matter: if it worked he would be very wealthy but if he lost it all it was also fine because he was young and he could start again if he needed too.

While I could not disagree about pension funds being too boring for a 25 year old (because of regulation 28 restrictions) I had to disagree with him about his ability to afford to lose it all and start again in 5 years time. What he (and most people) failed to realise is the critical importance of time in the market. Much has been written about the lack of a savings culture in SA and while there are many reasons for this, the overall cost to the economy is staggering. One of the more significant consequences is that so few people manage to retire financially independent. The ultimate cost of not starting early enough is that we don’t benefit from the power of compounding for long enough.

A few years ago there was a clever advert for one of the asset management companies which told the story of a peasant farmer who saved the emperor’s daughter. As a reward, the emperor offered the peasant anything he desired. His request was simple: one grain of rice on the first square of a chessboard and doubling every square thereafter until each square had been covered. Apparently there is not enough rice in the entire world to cover the last square.

Mathematically, this rice equation can be expressed as follows:

Square 1  (1 grain), Square 2 = Square 3 = Square 4 =  and so on until the 2nd last and last squares which can be expressed as  and . What is more significant is that the amount of rice on the second last square is half the amount on the final square – that’s the power of compounding!

It is unlikely that you will ever experience this kind of return from the market – this sequence, where the amount doubles each year, represents a return of 100% pa. However, it is not unrealistic to receive a return of around 15% pa from equities* and in this case, the capital would double every 4.8 years. There is a useful formula, called the rule of 72, which can be used. By using the factors of 72 one can determine the rate of return or the time taken for that return. For example:

  • 9*8 = 72 – in this example, a return of 9% pa means that your funds will double every 8 years. Or if inflation is 8% pa, the value of your funds will halve every 9 years.
  • Similarly, at 12% pa, funds will double every 6 years, or at 15% pa this will take 4.8 years.

Perhaps another way of illustrating compounding and its powerful force over time is the following example. It concerns two 25 year old friends. Both want to save money, but while one of them starts immediately, the other decides to wait a bit, choosing rather to spend his surplus cash on “living the good life” and deferring saving to 5 years in the future. In the example, friend A starts by saving R1000 per year for 5 years and then never saves another thing until he turns 65. Friend B, however, enjoys life for 5 years and then starts saving R1000 per year for the next 35 years in order to try to catch up the years he missed.

The picture below says it all…

The lessons are many:

  • The old saying may be trite but it is true: it is time in the market (not timing the market) that counts. The earlier you start saving, the less you need to save and the better you will be in the end.
  • Compounding is incredibly powerful but it requires time in order for it to work for you – each successive “time period” results in a doubling of your fund value.
  • Even though you might be young, you can’t afford to be reckless with your money, thinking that you can make it up if you lose it all. You can’t claw back the years you lose!
  • You don’t need a big amount to start saving…there are some funds that will accept debit orders of R100 pm and many that will take from R200 pm. Just start!

 

Note: it is reasonable to expect real returns of 7-9% pa from equity markets over time – where inflation is 6% pa, 15% returns would reflect the upper expectation.

ETF versus Unit trusts

You have a couple of hundred rand per month that you would like to invest and you have decided that you want to go the passive or index option. You like the idea of DIY and on top of that you are cost sensitive…you have also heard that unit trusts are expensive and if you can believe the advertising claims of ETFSA and Satrix* about being the cheapest way to invest, then you would be foolish to opt for anything but an ETF. But are ETP’s (ETF’s and ETN’s) really cheaper than unit trusts and even if they are, are they as safe as unit trusts (from an investor protection point of view)?

By way of comparison let’s look at 2 funds that track the same index: the Satrix Dividend Index ETF and the SIM Dividend Plus Index Fund unit trust. For the record, they are both passive funds that track an index that comprises the top 30 dividend paying shares (on a forecast basis) on the JSE. So they effectively comprise the same shares with the only difference being that one is an ETF structure while the other is a unit trust fund.

For starters, the unit trust version has a lower monthly investment amount of R200pm than the ETF which has a R300 minimum debit order amount. The ETF has a lower minimum lump sum investment of R1000 compared to the R5000 UT minimum.

As far as fees go, there is no initial fee to access the unit trust version. Depending on how you buy the ETF version, however, you could pay initial fees – either in the form of brokerage if you opt to go via a stockbroker or in the form of initial fees via the Investment plan. For the sake of this exercise let’s assume you opt for the Satrix investment plan (you only have R300 pm to invest and it is cheaper than going via a stockbroker).

In the case of the Investment plan, you will pay a fee of R3.50 on the debit order as well as a brokerage fee of 0.1% (excl VAT) each time you buy or sell the ETF (on R300 that is R3.80 each time you buy or sell). On top of this you will also pay an annual administration fee of 0.75% on amounts below R100000 (0.65% for amounts between R100000 and R500000 and this decreases as your value grows) and then there is the fund fee of 0.456% (excl VAT). By contrast, the only fee on the unit trust is the annual management fee of 0.45% (excl VAT)!

The final comparison comes down to investor protection. In this case, both the Satrix and SIM funds are registered collective investment schemes and this offers a great deal of protection to the investor in the case of something happening to either Satrix or SIM. In South Africa, all unit trust funds are registered under the collective investment schemes act, but this is not the case for all ETP’s. For example, many of the exchange traded notes are not registered as collective investment schemes and they carry additional risks that investors need to be aware of and that could leave them exposed if something went wrong.

In summary then, the cheapest way to “own the market” is not in fact via the Satrix or ETFSA platforms, it is currently, surprisingly to many, to buy the SIM Smartcore range of funds**. In this instance, when comparing like for like, the unit trust version is quite a bit cheaper than the equivalent ETF fund.

SIM Div Index

Satrix Div Index

Structure

Unit trust

ETF

Min d/o

R 200

R 300

Initial fee (d/o)

nil

0.1% +R3.50

Min l/sum

R 5 000

R 1 000

Initial fee (l/s)

nil

0.10%

Annual fund fee

0.45%

0.45%

Annual admin fee

nil

0.75%

 

Notes:

*Satrix/ETFSA’s claim that their annual fees are about 1/3 of the average actively managed unit trust fund is meaningless. You will always pay more for an actively managed fund than you will for a passive/index fund. In order to make an honest comparison, they should compare their fees to that of the passive/index unit trust funds, which is what this article does and shows that they are not in fact cheaper than unit trust equivalents.

**the writer holds no interest in SIM Smartcore, other than to make use of their range of funds. Interestingly, Satrix is now wholly owned by SIM Smartcore.

Fundisa revisited

Just under 6 years ago, ASISA (Association of Savings and Investments in South Africa) launched what should have been a really exciting education savings initiative called Fundisa. The idea was to provide a unit trust alternate to the traditional insurance based products. In addition, government was offering a 25% bonus contribution to all investors. On the face of it, Fundisa ticked all the right boxes: flexible, transferable, low cost, low minimum investment and best of all, an additional bonus paid into the investment by government.

Initially huge fans, we encouraged many people to take advantage of what seemed like a great offer…until we did the maths and discovered that Fundisa was fatally flawed for at least 2 reasons. The fund invests in “cash” and the bonus is capped on too low an amount!

In brief, Fundisa works as follows: subject to a maximum contribution of R200pm, government adds 25% to the investment. So for every R200 that is invested by the investor, a bonus of R50 is contributed by government. Following some basic maths, I calculated that the projected return using Fundisa would look something like this (assuming R200 from me + R50 from government and a 7%* per annum return – this also assumes no escalation on the contribution because the bonus is capped on the first R200).

Year

Fundisa projected value

1

R 3 098

2

R 6 420

3

R 9 983

4

R 13 802

5

R 17 898

6

R 22 290

7

R 27 000

8

R 32 050

9

R 37 465

10

R 43 271

11

R 49 497

12

R 56 174

13

R 63 333

14

R 71 009

15

R 79 241

16

R 88 067

17

R 97 532

18

R 107 680

19

R 118 563

20

R 130 232

At the end of the term, the full amount is payable to an approved tertiary educational institution. The investor also has the option of taking the funds in cash and using them for anything else but they would then forfeit the bonus contribution and any growth on it (i.e. they would get around 25% less than the projected amounts).

In some other work we have recently done, we calculated that the cost of a 3 year degree in 2023 (assuming an increase of 10% pa) would be around R460000 and you would need to be saving around R1700 pm to achieve this# – clearly the R250 pm is not anywhere near enough to fund tertiary education at a university and investors need to be alerted to the fact that they are unlikely to be able to afford to pay for their studies using this fund alone. As far as we can see, there is no “disclosure” of this fact anywhere on the website. (As a matter of interest, the comparative projected cost of a 3 year degree in 2033 is more than R1.2m.)

My second and perhaps more serious criticism of Fundisa is that it is too conservative in its investment approach. You cannot sit in “cash” for 20 years and expect a half decent return! So we compared two alternate scenarios to Fundisa using more appropriate investment portfolios: we compared R250 into Fundisa versus R200 into a typical “balanced” fund and R200 into a typical equity fund **.

The return assumption on the balanced fund was 11%pa (CPI+5%) and the equity fund was 14% (CPI+8%). The results are as follows:

Year

Fundisa

Balanced Fund

Equity Fund

1

R 3 098

R 2 525

R 2 560

2

R 6 420

R 5 342

R 5 503

3

R 9 983

R 8 485

R 8 885

4

R 13 802

R 11 991

R 12 772

5

R 17 898

R 15 904

R 17 239

6

R 22 290

R 20 269

R 22 374

7

R 27 000

R 25 139

R 28 275

8

R 32 050

R 30 573

R 35 058

9

R 37 465

R 36 635

R 42 854

10

R 43 271

R 43 400

R 51 814

11

R 49 497

R 50 947

R 62 112

12

R 56 174

R 59 367

R 73 948

13

R 63 333

R 68 761

R 87 552

14

R 71 009

R 79 243

R 103 187

15

R 79 241

R 90 938

R 121 157

16

R 88 067

R 103 986

R 141 811

17

R 97 532

R 118 544

R 165 550

18

R 107 680

R 134 786

R 192 833

19

R 118 563

R 152 908

R 224 192

20

R 130 232

R 173 128

R 260 233

Using the return assumptions above, it should be clear to see that after 10 years in a balanced fund and just 6 years in an equity fund you would be better off than in Fundisa – even without the 25% government bonus!

But this is all just theory, what has actually happened? To look at this we compared the “average” fund in each of the relevant sectors and used the relevant historic returns to calculate the projected values of each:

 

Historic returns 10 years to 31 March 2013

Fund

Sector

Ave return

Fundisa SA IB Short Term

8.58%

Ave Balanced SA MA High Equity

16.78%

Ave Equity SA EQ General

20.92%

Based on these assumptions we get the following results:

 

“Fundisa”

“Balanced”

“Equity”

1

R 3 121

R 2 593

R 2 644

2

R 6 707

R 5 813

R 6 056

3

R 10 813

R 9 781

R 10 423

4

R 15 495

R 14 643

R 15 974

5

R 20 818

R 20 573

R 22 993

6

R 26 852

R 27 774

R 31 831

7

R 33 676

R 36 488

R 42 918

8

R 41 374

R 47 004

R 56 785

9

R 50 041

R 59 661

R 74 086

10

R 59 780

R 74 861

R 95 628

Based on the above you would have been better off after just 6 years in an average balanced fund and 4 years in an average equity fund. The overwhelming conclusion is that for the first 5-10 years, Fundisa could be a half decent prospect but after that is gets left behind and is too conservative for anyone wanting to save for any period longer than this.

At the time of investigating all of this we also wrote to ASISA to suggest some alternate fund options and their response was probably the most disturbing thing of the whole exercise:

 

“While the approach suggested…is correct for the majority of investors, the Fundisa Fund was structured as a low risk investment vehicle for a very good reason: it primarily targets low income earners who, as a result of their financial situation, cannot afford to take any risk with their money.” Their response continued…“also, the majority of low income earners are not serviced by financial planners who can assess their risk profile and structure and maintain a savings and investment portfolio accordingly. This is another reason why Fundisa had to be designed as a low risk product.”

 

Seems to me that even the learned chaps at ASISA don’t really understand “risk” – volatility is just one measure and needs to be considered alongside (many) other factors including inflation. To label Fundisa a “low risk” investment is to take a very narrow view of risk! If one uses inflation as a measure of risk then Fundisa could in fact be considered a high risk investment. Perhaps it should be more correctly labelled a “low volatility, low growth” investment?

 

And finally “therefore, while Fundisa will provide investors with solid inflation beating returns, it will always return less over the longer-term than an equity fund…historically, Fundisa has delivered a marginally higher return than a money market fund.”

 

Contrary to this, the long term real returns from the respective asset classes suggests that there is very little probability of cash and bonds ever providing “solid inflation beating returns”. To my mind, if we follow this reasoning then rather than educating and uplifting society we are condemning the poor to a life of poverty. To suggest that “they” don’t understand and are therefore restricted to an inferior option is patronising in the extreme and any product that is not good enough for “us” is not good enough for “them” either.

 

My advice is to stay away from Fundisa!

 

 

Notes:

*7% is a reasonable return expectation from this kind of fund in the current interest rate environment. The return for 12months to 31 March 2013 was 6.09% from the Stanlib option and 7.55% from the Nedgroup fund.

#this assumes a return of CPI+5% over the term as well as annual increases of 6% (CPI) on the premium.

** R200 because there would be no bonus if you did not use the Fundisa fund.

Gold coins

One of my clients presented me with an advert for “South Africa’s Randiest Hedge” which was carried in the Sunday Times on 13th March this year. It is an advert for gold coins and goes on to proclaim the virtues of investing in gold, especially if one is “feeling switched off by current financial offerings”. The basis of the advert is the fantastic return of 1550% over the past 20 years (1992 to 2012). Who would not be interested in something like that?

1550% over 20 years sounds incredible, until you do the maths. It equates to a compound annual return of 13.8%. If one looks at the graph, however, for the first 10 years at least, the return was close to 0% pa. It is only in the past 10 years that the “randiest hedge” has really performed and during this period, the return has been around 25% pa. Not bad indeed (so long as you did not bail during the first 10 years and miss the past 10).

What about the claim about being South Africa’s Randiest Hedge, is there anything else that has done as well over the period? A quick look at the ALSI shows that it returned 17.02% pa over the same 20 year period. If you had invested in the ALSI then your final value would have been 2937% higher. There are few equity unit trusts that have been around that long, but the best fund over that period is the Investec Equity Fund which delivered 18.48% pa. if you had invested in that fund over the 20 year period then the final value would have been 3917% – much more than double that of the “randiest hedge”. In fact, 11 of the 12 equity unit trusts that have been around that long would have delivered better returns than the gold coin investment over the 20 year period. For the record, the estimated CPI over the same time was around 6.4% – so they have all comfortably out-performed this figure.

I have no idea what a “randiest hedge” is and I am also not out to knock gold as an investment but if you are going to buy gold then you need to know the following:

  • It is very difficult to value gold – there is no cash-flow, dividend or pe ratio.
  • It is a very emotional “investment” and is often seen as a “safe-haven” when inflation is a concern or when things are looking volatile on the markets.
  • The value of gold is largely sentiment driven -fear and greed are large drivers of the value of all assets and gold is as much (if not more) subject to these two emotions as any other investment.
  • It is not a sure thing and you have no guarantee that you can sell it (it will depend on demand, just like any other investment).
  • The long term return on Kruger Rands is around 15.5% pa (1970 – 2012). Over the same time the JSE has returned just over 17% pa – your final Kruger Rand value on R100 invested would have been around R55000 while the return from the JSE would have been around R103000.
  • This highlights the significant effects of compounding – just 2% more per year over a 40 year term will effectively mean more than double the final value.
  • While gold may add diversification to your portfolio, there are significant periods where it has not provided any growth at all – 1992-2002 is a case in point. Can you (and will you) sit these out?
  • If you are buying gold because you think it is the end of things as we know them, then you are better off buying physical gold coins or bars than investing in gold (coins) via some internet based platform. It wont help to own gold via a platform if the system collapses (not sure that it will help to own coins either but maybe that’s because I don’t own any, yet!).

It’s different this time

“It’s different this time!” 4 words that should make any serious investor very nervous. But either markets are seriously over-heated or perhaps, it is different and maybe the markets are telling us that a whole lot of other stuff, like inflation in particular, is not as low as government would have us believe.

Officially, inflation is 5.4% (Jan 2013 www.resbank.co.za). Now we know that over long periods of time, the different asset classes give us different real returns with the long term average for equities being around 7-9% per annum. So based on an inflation figure of 5.4% we should expect the equity market to be returning around 14.4% pa max (5.4%+9%). The 30 year return figures support this number.

However, the 10 year figures do not. In fact, 10 year equity market nominal returns are just under 19% pa* and this should put the CPI number at around 10%. Officially, CPI over this period has been 5.3% which means that the markets have then given real returns of just under 14% pa. If this is the case then we are due for a period of pay-back or mean reversion.

However, in a the recent “Bull and Bear” report released by Glacier, almost 60% of the fund managers surveyed thought that the market was fairly valued (40% think that it is over-valued) but they all expect it to deliver returns of between 9-13% in 2014 (nominal).

We know that fund managers can and do get it wrong, but if they are correct and the market is not hugely over-valued, perhaps it is telling us something else? Perhaps it is telling us that the CPI number is not correct? If we know that equities should give real returns of around 7-9% pa then perhaps the market is telling us that inflation is closer to 10-12% pa and not the 5.4% the government wants us to believe? The recent round of wage negotiations and salary increases support this and suggest that most of our working population don’t believe the 5.4% figure. Petrol and electricity increases also seem to support a different number too and I know that 10% is certainly far closer to my reality.

Either the equity (and property) market is over-valued or CPI is much higher than we are being told – it’s not different this time.

 

*Source: Prudential Asset Management 10 year returns to Dec 2012