Longevity and low returns – a deadly combination for investors

As a financial adviser, chances are the bulk of your clients’ investments sit within a retirement fund – either an employer fund or in a retirement annuity (RA). Particularly with the increase in the tax benefit of retirement funds in March 2016, this type of investment remains an excellent choice for long-term investing. But what has become more challenging is constructing the underlying portfolio for this retirement vehicle.

Keeping up with longevity

Rising longevity is real: someone born in 1947 is expected to live until the age of 85. Compare that with someone born in 1987 – the latter is now expected to live to the ripe age of 97! As a result, the time your average client will spend in retirement will soon be nearly as long as the time he or she spent accumulating life savings. It goes without saying that to build up enough savings to last for life, your clients’ money needs to be invested for growth. A strategy that beats inflation by a substantial margin is what your clients need to keep up with their retirement needs.

Reaching goals is harder in a low-return environment

That is where the challenge comes in. Whereas in the previous century, globally, equities beat inflation by 5-6% per annum on average over the long term and bonds by about 2%, these returns are unlikely to be repeated in the next decade or perhaps even in the next two decades.

‘The unprecedented lowering of global interest rates in the wake of the Global Financial Crisis has led to a change in the pricing of all assets, due to the significantly reduced outlook for returns from cash and bonds,’ says Frederick White, co-manager of the Sanlam Investment Management (SIM) Balanced Fund. ‘This being said, equities is still the asset class that is most likely to produce inflation-beating returns over the long term, going forward.’

‘Foreign assets are priced such that on a relative basis, growth assets like equities should continue giving the type of outperformance over fixed interest assets that it gave historically,’ says White.  Both these sets of returns are just likely to be lower than their respective long-term histories. ‘It is possible to invest at higher valuation levels than the past and still expect equities to outperform bonds by the same margin than it historically has,’ says White.

Many local shares have become cheap

Given the poor earnings outlook for many South African companies and the current price/earnings ratios of the major JSE indices, you may think that local equities are currently expensive. However, SIM is of the view that the JSE is currently reasonably priced. Any local equity measure is heavily influenced by Naspers, which has grown to almost 20% of the index. Once SIM excludes Naspers from its valuation measures, local equities ex Naspers seem much more palatable, especially in a global context of higher priced equities. Furthermore, companies that primarily derive their earnings from South Africa have become cheap.

An outlier such as Naspers needs special treatment

Naspers has outperformed the broader market, as measured by the SWIX, by more than 20% p.a. for the last decade. Despite Naspers’ astronomical PE ratio (around 120 recently) the share still offers upside, just not when measured by valuation methodologies used for more conventional companies. The SIM Balanced Fund increased its exposure to Naspers last year and year to date the share has yet again outperformed the market by nearly 40%.

However, since Naspers is valued on a different methodology, which could change and since the company itself operates in a non-traditional sector where there is a higher risk of unforeseen change, this share poses a higher than average risk of  large drawdowns. White remembers only too well the case of Didata two decades ago, which rose rapidly to become the largest counter on the JSE. It took a mere 24 months for it to drop from the largest of the large to small cap status.  Admittedly these are vastly different companies, but the ability for investors to accurately pre-empt a big change in the competitive landscape faced by an online platform in China certainly is limited.

This is why SIM has put protection in place for Naspers to reduce investors’ losses in the case of a big drawdown. By doing that, there is the risk of incurring an opportunity cost: should the Naspers share price rise by even more than expected our fund’s exposure would be capped. But at least by the time that happens investors would already have received massive upside and could rest assured knowing that they’re not exposed to the full potential downside of the share’s price.

But the portfolio managers’ protection strategies don’t stop at Naspers – it extends to the rest of the equities in the portfolio too.

The SIM Balanced Fund seeks out growth while protecting against drawdowns

‘Because investing in equities is similar to taking a ride in a hot air balloon, SIM remains aware of managing the risks appropriately,’ says White. ‘It’s a great ride and it can lift you to great heights, but there’s always the element of risk involved with  an open flame near the wall of a balloon.’ SIM has protected a significant portion of the Fund’s equity exposure through the use of protective derivative structures. The key objective is to firstly protect investors against a portion of any significant drawdown in equity markets (greater than an approximate 15% move) and secondly to not give up those gains when markets recover. This should in the long run enhance the returns of the Fund, while also contributing to lower volatility of returns.

‘So we effectively follow an approach of investing in the most likely growth opportunity and putting in place “calamity insurance” where that opportunity might have an increased risk of drawdown. We aim to get the best of both worlds: vigilantly seeking returns, being bold when necessary, and also cautiously searching for protection.’ The fund managers also reduce the amount of protection in the Fund when markets are cheap.

White concludes, ‘By strategically protecting the equity portion of the SIM Balanced Fund we continue to give investors good exposure to growth assets – making it more likely for them to reach their investment goals even in a low-return environment – while simultaneously reducing the risk of large drawdowns.

Fred White

Head of Balanced: Sanlam Investment Management (SIM)

Frederick White was appointed head of Sanlam Investment Management (SIM) balanced products in July 2016. He joined SIM in November 2002 as sector head for resources and manager of the resources unit trust. He has held numerous senior roles within the investment team, including head of strategy, head of process and head of asset allocation and macro research. Prior to joining SIM, Fred worked at Investec Asset Management in a variety of roles, initially as an equities dealer, followed by a number of research positions in non-mining resources, global oil and gas and small cap fund management, as well as in management of the company’s Namibian office.

Fred has operational and corporate experience in the mining sector, having worked as a personal assistant to the chairman of Gencor, as new business development officer in the company’s international gold division and on various projects at other departments in Gencor and a number of its mines. He holds an MBA from Stanford University and both a B. Eng cum laude and M. Eng cum laude from Stellenbosch University. He passed the IMRO exam in 1999 and obtained the CFA designation in 2003.

This publication is intended for information purposes only and the information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Although all reasonable steps have been taken to ensure the information in this document is accurate, Sanlam Investments does not accept any responsibility for any claim, damages, loss or expense, howev­er it arises, out of or in connection with the information in this document. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information. The contents of this document remains the property of Sanlam Investment Management (Pty) Ltd and may not be reproduced without the written permission of Sanlam Investment Management (Pty) Ltd.

Sanlam Investment Management (Proprietary) Limited is a Licensed Financial Services Provider. Sanlam is a full member of ASISA. Sanlam Collective Investments(RF) Pty Ltd., a registered and approved Manager in Collective Investment Schemes in Securities. Collective investment schemes are generally medium- to long-term investments. The Sanlam Investment Management (SIM) Balanced Fund is a multi-asset, high-equity fund and is exposed to equities, which means the prices will go up and down. The Retail class is the most expensive class offered by the Manager. The maximum fund charges include (including VAT): An initial advice fee of 3.42%; annual advice fee of 1.14% and annual manager fee of 1.25%. The most recent total expense ratio (TER) is 1.67%. Please note that past performances are not necessarily an accurate guide of future performances, and that the value of investments / collective investment units / unit trusts may go down as well as up. Commission may be paid and, if so, would be included with the brokerage charges, securities transfer tax, auditor’s fees, bank charges, trustee fees and levies in the overall costs, which will be levied against the fund. A schedule of fees and charges and maximum commissions is available from the manager, Sanlam Collective Investments(RF) Pty Ltd on request. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total value of all assets in the portfolio including any income accrual and less any permissible deductions from the portfolio. Portfolio performance is calculated on a NAV to NAV basis and does not take any initial fees into account. An annualised growth rate is used for all performance data of 12 months or longer. Income is reinvested on the ex-dividend date. Total return performances are published. The source of performance data and risk statistics is Morningstar. Actual investment performance will differ based on the initial fees applicable, the actual investment date and the date of reinvestment of income. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The manager has the right to close the portfolio to new investors in order to manager it more efficiently in accordance with its mandate. If the fund holds assets in foreign countries and could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds, macroeconomic, political, foreign exchange, tax risks, settlement risks and potential limitations on the availability of market information. Derivatives are instruments generally used as an instrument to protect against risk (capital losses), but can also be used for speculative purposes. Examples are futures, options and swaps.