Investment Newsletter (and related info)
November 2008
Equipping investors to deal with turbulent times
Overview
Nobody knows for certain what will happen in the short term. Share prices will go up and come down. However, we have much greater clarity over what will happen in the long term - investments in shares have been and will continue to be a key component of wealth creation.
Whilst there is much turmoil and bad news, such scenarios often present opportunities for patient and sensible investors.
It is therefore important to stick to your strategy and not be distracted by emotion.
Causes of the crisis
- Inappropriate loans made to high-risk borrowers
- Repackaging of these loans & selling them to investors searching for yield
- Excessive leverage of the investment banks
- Poor understanding of risks by credit rating agencies
- Lack of transparency and poor regulation
... all relied on house price’s continued increase (which began falling last year)
Impact on SA companies
- Low direct exposure to sub-prime
- SA banks relatively unscathed as a result of
- Exchange controls
- Tougher monetary policy (higher interest rates)
- Legislation (National Credit Act)
- Indirect impact potentially much greater
- Slower economic growth
- Lower exports
- Falling commodity prices
- Negative sentiment
Understanding the investment realities
Fact 1 – Recent returns in context
- Short-term returns have been poor across most asset classes
- Longer-term returns (5 years and longer) remain acceptable
Fact 2 – Unrealistic expectations
- Recent returns (last 5 years) have been extraordinarily good and are well above long-term averages
- Historical returns above inflation over the last 100 years – and a reasonable proxy of what expectations should be - are as follows:
Equity: Real return 7%, Measurement period: 7 years
Balanced Fund: Real return: 4%, Measurement period: 5 years
Cash: Real return: 1%, Measurement period: 1 year
Fact 3 – Risk & return are related
- Over the long-term equities have significantly outperformed cash, bonds and inflation
... but have done so with greater risk
- Over longer periods of time, cash may actually be a more risky asset class (in terms of the probability of achieving your objectives) than equities
Fact 4 – Diversification adds value
- By diversifying your investments across asset classes, currencies, sectors and stocks you are able to reduce the risk of the portfolio
Fact 5 – Time is your friend
- The longer the investment horizon, the greater the reduction in risk
- Be careful of trying to time the market - a comprehensive study done by the University of Michigan over an 80-year period showed that investors consistently earn lower rates of return by switching between funds at the wrong time (up to 5% p.a.)
- Being out of the market is risky. For the 10 years to 30 September 2008, the ALSI returned 432%. If you missed the best 10 days your return halved
Fact 6 – Maintain your strategy
- After market corrections it pays to stay invested, as subsequent returns are often good
- There is a significant opportunity cost of moving into cash for long-term investors
What should you do?
- Educate yourself – understand the facts
- Focus on what you can control
- Your objectives
- The time horizon to achieve these objectives
- Your strategy
- The risk you need to accept to achieve your goals
(and whether you can tolerate this risk) - Employ experts to assist in decision making
Courtesy: Nedgroup Investments
The truth about money market funds
The global credit crisis has seen investors placing an increased focus on assessing the risk attributes of their portfolios as not even offshore money market funds have been unscathed. In the past money market funds have been considered risk free investments, with some even marketing the fund with capital guarantees. Defaults and the widening of credit spreads in global credit markets have seen that what was always perceived to be very secure investments, incurring capital losses. As this possibility was never really perceived as a real one, it left many investors in shock. Investors have tended to focus purely on the relative yields of money market funds with little appreciation of the credit exposures of funds. When these funds started experiencing capital losses we fielded numerous calls from investors asking how safe the RMB Money Market Fund is and the implications of the credit crunch on fund yield and capital value of the portfolio.
Local money market funds not exposed to sub-prime
High capital stability, but no capital guarantee
Firstly we need to stress that local money market funds are sheltered from the types of exposure causing the fallout offshore by exchange controls and our CISCA regulations being fairly restrictive on the types of instruments held. Reassuringly, investors can draw a great deal of comfort that our money market fund is highly capital stable and managed in very conservative manner. The RMB Money Market Fund currently has no offshore assets despite the fact that CISCA allows deposits with the local branches of international banks. Direct deposits with offshore banks are prohibited. It is,
however, prudent to be aware of the risks attached to money market funds, though they may be perceived to be insignificant, as it increases with economic slowdowns and especially systemic market stress as witnessed in global credit markets.
Money market funds are often misunderstood, but are best explained simplistically as a pool of wholesale fixed deposits. Instead of taking out a fixed deposit with a bank, one can invest in money market funds which provide exposure to a broad mix of short term debt instruments deposits. When taking out a fixed deposit you are exposed to the risk that the bank may default and be unable to pay you at maturity of the deposit. The bank guarantees your capital, but this is only as good as its financial ability to meet its commitments. This risk is reduced when the bank is well capitalised and in the event of bank failures government may protect deposit holders to limit systemic risk. Money market funds reduce your credit risk through a diversified exposure to issuers outside the banking sector ie corporate, parastatals, government etc providing yields significantly above those available to a retail investor. Additionally, they are limited to a maximum fund duration of 90 days, and a limit of one year’s maturity on any one instrument, all but negating interest rate risk.
Local money market funds are still very low risk investments
Cutting through all the noise, local money market portfolios are very low risk investments, as exposures to local funds are directly immune to the global credit crisis. The fund would indirectly be exposed to the economic impact that arises locally as a result of credit strains and slower growth. However, money market funds have been around a long time through many economic downturns, and remained unscathed, never losing capital. There is no high risk (sub-prime, leveraged loans) component to domestic money market funds. Courtesy: RMB Asset Management
Just when you thought it couldn't get worse
You will hear much discussion around the terms 'Wall Street' and 'Main Street'. Wall Street is synonymous with the US financial system and Main Street represents the US consumer. It is clear that the average American sees the current crisis as a Wall Street problem and the bailout plan (which taxpayers are expected to pay for) is therefore very unpopular. The perception among those opposed to the Bill is that Wall Street had a party; now it has a hangover, and the people being asked to clean up the mess (i.e. the taxpayers) feel they weren't even invited to the party.
But, in fact, they were at the party. The average American family has 11 credit cards. They lived in a world where house prices supposedly only went up, and therefore home equity withdrawals (refinancing your house in order to spend more) fuelled the party until borrowers are now drowning in debt. Consumers are blaming the barmen (the banks), who made lots of money selling them the drinks (debt), and they are blaming the Government for not having regulated how much they could drink.
Another prevailing myth is that this bailout is only about Wall Street. The mere use of the word bailout angers taxpayers, as it implies that rich bankers will be bailed out of trouble (which is partly true). It implies that Wall Street, while fiercely backing capitalism when profits were aplenty, is now backing a more socialist model in order to spread the losses across the nation's taxpayers.
But, despite emotions, and tempting as it is to see those who profited enormously from the subprime debacle punished for this, the global financial system is the plumbing of the global economy, and if the financial system were to melt, the implications for the global economy, the Main Street and consumers in general, are severe. In addition, if the tech bubble was a flat tyre, this crisis is the seizing of the engine. The economy cannot simply roll to the side of the road to change a tyre, and therefore the significance of this situation should not be underestimated.
So what does the future hold?
In the short term, things could get worse. If the bailout package is not passed in some form or another, you may see further banking acquisitions/failures. The risks of contagion as the crisis spreads to industry also increase substantially. However, sanity should prevail, and the message is probably hitting home to Congress and indeed the US public as we speak, so the possibility of a deal certainly does still exist. Politically this is very advantageous to Obama's campaign.
Value will present itself at some point and the world will move on. Exactly when that is, however, remains unclear. Investors should be careful of making emotional decisions during extraordinary times. It is times like these that illustrate clearly (and sometimes painfully) the benefits of portfolio diversification (or lack thereof). This is exactly why portfolios should be structured according to the individual investor's specific risk profiles. For those who sacrificed some of the upside when times were good, the fact that they were properly diversified means that the current turmoil - although uncomfortable - shouldn't be too painful. Courtesy: Jeremy Gardiner, Director at Investec Asset Management
The truth about money market funds
TAX-FREE INVESTMENT OPPORTUNITY
As bad economic and market news continues to dominate, investors are looking for new ways to grow their wealth and realise excellent returns – without undue risk.
Preference Shares is the one investment class that provides a los risk, stable source of tax, and provides a free income in good and bad times.
Suited to corporate investors or high net worth individuals, there are two Preference Share options, Redeemable Preference Shares and Perpetual Preference Shares.
The best suited to the current conditions.
Preference shares are shares issued by a company which rand as a claim against the issuer in preference or ordinary shares but behind any other claims such as unsecured debt. However, in the case of redeemable preference shares, the subordinated nature is mitigated by combining the preference with a guarantee.
Preference shares are normally used by high net worth individuals who have utilised their interest exemption or corporate investors who are South African tax residents, are in a tax – paying position, have surplus cash and need secondary tax – paying position, have surplus cash and need secondary tax on companies (STC) credits. They generally offer higher after – tax returns than a comparable interest – yielding investment.
In most instances dividend returns are linked to a percentage of the prime lending rates or Johannesburg Interbank Agreed Rate and are payable quarterly or semi-annually.
A fixed dividend rate is offer to a small percentage of preference shares.
Dividends are currently tax free if they are held for longer than three years or in a material change in the terms of the preference shares do not occur. Preference shares can be divided into two major categories – redeemable preference shares and perpetual preference shares. As each category has its own level of risk, investors should check that they are earning an appropriate return.
Redeemable preference shares
Redeemable preference shares are packaged by banks and insurers for distribution to the corporate market. They are issued off-market as a private trade, and are unlisted. As these are typically wholesale investments, denominations are R 1 million and R20 million. Redeemable preference shares are unlisted debt equivalent investments.
They provide a capital guarantee when combined with a put option or guarantee, to a highly rated banks or institutions.
These investments are redeemable on a fixed date, normally three years after issue, and capital is repaid in full. Investors in these instruments have a no marker risk.
Dividend payments are prime rate – linked and cumulative – the investor’s claim for dividends accumulates over time at the contracted dividend return. Investors invest in these instruments as a buy-to-hold investment, in investment sizes than can exceed R400 million.
Secondary market trades rarely happen and exist only by private treaty.
As an alternative to investing directly in preference shares, investors can invest in collective investments whose underlying assets are preference shares. One such fund, the Sanlam alternative Income Fund, is essentially a redeemable preference share conduit.
Perpetual preference shares
Perpetual preference shares have equity characteristics. Investors have no claim to their capital as these investments are non – redeemable, except in the event of specified credit events.
The return is linked mainly to the prime lending rate. Investors have no claim to dividends unless and until they have been declared by the issuer. Since dividends are issued on preference shares before being issued on ordinary shares, the likelihood of dividends being passed is small, but payment is not certain.
Perpetual preference shares are first distributed in the primary market, mainly by private banks, and investments can be made in relatively small denominations. Instruments are traded though the normal stock broking channels.
Although trade is thin and liquidity is limited, trading volumes are not limited. Most preference shares listed on the Johannesburg Securities Exchange (JSE) are perpetual preference shares.
Significant market risk is assumed by investors in these instruments. This is because in the investor, when exiting from the investment, has to sell the listed investment in the secondary market at a market price that can fluctuate.
For various reasons the selling price can fall below the original issue price.
This may happen due to an excess supply of perpetual preference shares issues, overselling by investors ( for example due to rumours of tax changes or new issues that drive down the price of existing issues) or the impact of low liquidity.
Currently both types of Preference shares play a role and investors should contact their financial advisor of financial services provider regarding the best opportunities for them.
Courtesy: Tienie van der Mescht, Managing Director, Sanlam Collective Investments
Read more on Preference Shares and how to apply
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