Author: zombie

 
What are ETF’s

What are the benefits of using ETF’s

What are some of the shortfalls of ETF’s

Potential strategies to make use of ETF’s

It is said that simplicity is the ultimate sophistication. Not only is it possible, but in my opinion also preferential, to keep your investments as simple in composition as you can. The notion that complicated or technical products have a superior ability to deliver higher returns is a complete nonsense.

If you can get to grips with what you are invested in and why, you are far more likely to follow through with your long-term investment strategy during the tough times – and there will always be tough times when you seek real growth in the value of your investments.  

I may not be a fan of the abundance of acronyms in our industry but I am a fan of investment products that do what they say on the can and I am therefore a strong supporter of ETF’s.

What are ETF’s

ETF’s or  Exchange Traded Funds are essentially financial instruments that trade as a single share on a stock exchange but usually represent a much broader range of assets (Shares, bonds, property). For example; if you a buy a JSE Top 40 ETF, you purchase a single share  but you gain exposure to the 40 largest stocks that make up the lion’s share of the South African equity market. 

ETF’s cover a broad range of asset classes, some of which have historically been very difficult for the small retail investor to access independently, including bonds, property, and even commodities.

ETF’s are frequently designed to track or mimic the performance of some asset class or type of investment (shares, bonds, property, commodities) and do not attempt to outperform the benchmark. These are called passive or tracker ETF’s and are usually the lowest cost options.

There are some pseudo-active ETF’s that make slight adjustments to the benchmark composition; for example by equal weighting all the constituents of an index rather than replicating the market capitalisation of the index. These can be useful when you want to avoid excessive exposure to sectors that have a heavy weighting in a particular index – like the resources/mining sector, for example, which makes up almost 40% of the JSE Top 40.

There are also ETF’s that add a more active investment style or objective to the mix and here you can think of ETF’s structured to replicate the highest dividend paying companies in an index for example.

What are the benefits of ETF’s

Diversification – through the purchase of a single share you can gain access to a large number of stocks or bonds which lowers the potential risk of loss if anything drastic happens to any specific stock or industry sector for that matter.

Tradeability – ETF shares can be bought and sold at any time during normal market hours on their respective stock exchange. They are therefore better vehicles by which to capture the volatility of intraday movements relative to unit trusts which only get priced once a day.

Liquidity – ETF’s are usually very easy to trade into and out of, with very little expense incurred as a result of bid-to-offer spreads, even in times of heightened angst within markets. Unlike regular shares, ETF prices are not subject to the vagaries of supply and demand issues as the market maker will usually keep the price of the ETF in close proximity to the NAV (Net Asset Value) of the underlying investments. This is an important feature which does not always get the attention it deserves when it comes to investment selection.

Low Fees – Because the majority of ETF’s are passive, meaning they are not trying to outperform a benchmark, they do not have the same running costs or overheads of the large actively managed funds and therefore attract far lower fee structures. Typical TER’s (Total Expense Ratio) range between 0.20% – 0.60%. (Active managers can charge up to 3-4% in fees)

No empty promises – All too often we hear of the failure of yet another ponzi scheme which has attracted investment capital by promising unprecedented return opportunities, usually within some very short space of time. They typically prey on those that are desperate to make up for lost time by buying into the promise of get rich quick salvation, only to find out that is not possible and they are in an even worse position than when they began. ETF’s are honest, simple and straightforward products that do what they promise on the can.

Options a plenty – You can use ETF’s to gain access to a wide range of investment types or asset classes both domestically and offshore. You can create your own balanced fund approach specific to your own needs at a fraction of the cost of some of the more mainstream investment managers.

Taxation­ – Unlike standard shares, investors will not pay any Securities Transfer Tax (STT) on purchases of ETF’s in South Africa, which is currently levied at 0.25%. ETF constituents or securities will be rebalanced and kept in line with the underlying benchmark by the product provider. This means that similar to a unit trust you will not attract any tax liabilities by virtue of having to trade to rebalance your portfolio yourself.  Trading activity is also minimised so costs are minimised.

Performance expectations– Much of the hype around adviser fees is based on their ability to select the fund managers that will potentially deliver excess returns over their respective benchmarks year after year. Since evidence would suggest that around eighty to ninety percent of active fund managers fail to beat their benchmarks after fees, this is possibly a layer of additional uncertainty (and costs) that can be eliminated up front by choosing to invest in simple passive ETF funds.If you can accept that you will receive benchmark performance from your investments, you will lock-in guaranteed lower fee structures rather than chasing the ‘promise‘ of potentially higher performance with guaranteed higher fee structures.

What are some of the shortfalls of ETF’s

ETF’s will almost always underperform the benchmark slightly. The ETF is expected to deliver the benchmark or index return less an adjustment for the fee. However, you do eliminate the risk or uncertainty of having an active manager underperform the benchmark by a significant amount after fees.

ETF’s are simple investment products which lack the ‘sex appeal’ of actively managed funds. There are no star fund managers who’s superior ability to select winning stocks or time markets make for better conversation around the table at dinner parties.  That’s assuming they are successful of course.

You will never be able to boast about the big winners and ‘multi-baggers’ (Like Google and Apple) that made you your fortune.  ETF’s are investment products that replicate whole asset classes and not individual shares that will quadruple with much ease. Of course you don’t have the same downside risk of making wrong calls either and let’s face it no one talks much about their big losers.

A word of warning on ETN’s – ETN’s or Exchange Traded Notes are products that are designed to play a similar role as ETF’s but they use derivatives and sometimes leverage to replicate the underlying asset which exposes you to counter-party risk*. The ETN issuer promises to pay you the equivalent return of the underlying asset rather than with ETF’s which are backed by the physical assets. The crisis of 2007/2008 taught us to never be complacent when it comes to counter-party risk ever again (Think Lehman Brothers and Bear Stearns).

Potential strategies to make use of ETF’s

Buy and Hold Strategy:

Identify your investment strategy and purchase a single or selection of ETF’s that will provide you with the return profile to meet your strategy objective. You do not rebalance the portfolio over time but rather let the portfolio mix reflect the performance of the asset classes within the portfolio. This strategy will work particularly well in a trending market. It is the least time intensive strategy and the easiest way of running a portfolio that you add to on a monthly basis. Make sure you understand the risk profile of the assets you choose and, even though you will not actively trade your holdings, continue to monitor your investment strategy progress over time.

Constant Mix Strategy:

Similar to the strategy above you identify your investment strategy and purchase a single or selection of ETF’s that will provide you with the return profile to meet your strategy objective.  On a quarterly or semi-annual basis you will rebalance the portfolio back to its original allocation. This will be achieved by selling the asset class that has done the best and buying into the asset class that has underperformed. This strategy will ensure that you take profits on the winners and add to the assets that have cheapened up over time, while maintaining the same proportion of assets identified as appropriate in your initial strategy. The constant mix strategy of rebalancing will perform well in more volatile or range bound market conditions and lag the buy and hold strategy in a trending market. As your circumstances change or you move into a different life stage you may want to consider resetting your base allocation.

Core and Satellite Strategy:

This strategy involves a compromise for those investors who want to try and capture the upside of price moves on individual stocks. Many investors tend to have a trading account with a broker that aims at generating returns in excess of the market through superior stock selection and or market timing. Under the Core/Satellite strategy, the majority (CORE) of the portfolio uses ETF’s to gain market exposure (Beta) from the asset classes that will deliver the long-term returns and in addition to this, investors have a separate trading account (SATELLITE) where they invest in more concentrated individual stock positions to generate returns in excess of the market (Alpha).

*Counterparty risk refers to the risk that the contract into which you have entered is not honoured by the other party (counter-party) as a result of insolvency or similar inability to discharge their obligations under the contract. 

 Please contact White Investments if you would like to set up an Exchange Traded Fund portfolio tailored to your specific needs and objectives. E-mail: info@whiteinvestments.co.za

I often say that investing is not complicated but it is important to understand the basics so as to avoid some of the more obvious pitfalls and perhaps some misleading marketing from time to time.

With this in mind, we will first look at some of the important issues related to understanding average investment returns and introduce you to some important concepts and terminology.

We will then consider some of the more practical aspects of how this information is important when looking at your investments.

The average can be misleading…..

If I were to achieve a guaranteed average return of 10% each year it would look something like the blue line of asset A in Figure 1 below.

After 10 years my cumulative return would be almost 160% and, since it was guaranteed, I would have no deviation from this average each year.  In other words, I would have absolute certainty of my returns and carry no risk to the outcome. This would be an average I would be thrilled with as an investor.

Unfortunately that is not how the real world works. Few assets deliver the same consistent return year after year. Even cash returns fluctuate according to prevailing interest rates.

The average return from an asset can mask the bumpy road an investor could travel over shorter time periods. Believe it or not, the green line in Figure 1 also represents a 10% average return but as we can see this average is comprised of alternating years of gains and losses to arrive at this number.

Figure 1: The 10-year return profile of two assets (A & B)

This  graphic shows why it is never wise to consider average investment returns in isolation and why we need to look at returns in the context of some sort of risk measure.

Standard deviation is ­­­the most common measure of risk used in the investment industry. The standard deviation will give you some indication of how big the range of possible return outcomes can be around the average. The larger the standard deviation the greater the chance of achieving a return that is significantly different to the average we were expecting in any single year.  

In Figure 1, as we have already stated, there is no dispersion of returns around the average 10% for asset A, and so the standard deviation is 0%. But with asset B, it is clear that the returns do deviate around the average, and in this case the standard deviation of asset B is actually 17%. This means that the returns from asset B could be 17% either side of the 10% average in any given year (That is returns range between -7% and +27%).

It is not hard to choose which of the two risk-return profiles any sane investor would opt for given the choice.

The average can lie……

Consider Figure 2 where you invest R100 in a portfolio of assets. After a year you have lost 50% but the following year you gain 100%, giving you a simple average return of 25%. That sounds pretty attractive on the face of it but it is quite clear that the actual return you have achieved is 0%.

Figure 2: If you invested with the following return profile

The example in Figure 2 illustrates the important distinction between using the simple or arithmetic average return versus the geometric average when considering investment returns.

The difference between the two results is that the arithmetic measurement assumes the two years are independent of each other.

(-50%+100%) = 50% divided by 2 = 25% (Arithmetic Return)

The geometric return on the other hand accounts for the fact that the two years are in fact dependent on each other:

Year 1: We start the year with R100 and lose half or 50% over the course of the year.

Year 2: We start the year with only R50 and, even though we double our money with a 100% gain over the year, we are only back to our original R100 value and have in reality made a 0% return overall (Geometric Return).

Note that the standard deviation in Figure 2 is also a high 75%, which should alert investors to the fact that the returns they are achieving come with a significant level of risk.

Practical implications to consider based on the above discussion on average returns:

         i.            An average return is unlikely to be representative of what you will experience in reality. Returns in any single year can deviate significantly from the average. Your investment strategy may be based on an average return of 12.5%, if you invest only in equities over the next ten 10 years, but during that period you may see an annual gain in the market of 40% one year and a fall in the market of -30% in another year.

       ii.            Despite the shortcomings of average returns, they remain useful when assessing a reasonable expected return profile and asset allocation strategy in the financial planning process. However, when comparing assets or funds you must be sure to use the geometric average returns and make sure you do so in the context of that asset or funds risk (standard deviation).

      iii.            Different asset classes display different risk-return profiles. Shares or equities will typically deliver average returns in excess of bonds and cash over the long-term but shares will also display a higher standard deviation. The success of your long-term financial plan will rely on you achieving a certain average return over the life of your strategy and your portfolio must be constructed of assets that will deliver those returns. This may mean you have to accept a higher risk or deviation of returns over shorter periods to achieve your objective.

     iv.            By being aware of the potential range of returns you may experience from any particular asset class, rather than just the average, you can avoid some of the more common mistakes investors repeatedly make. Don’t be caught out by the promise of a 10% average return (with a 26% standard deviation)and then sell your investments during a year where the market sells off by 30% or more because your strategy is failing.  These sorts of moves are entirely possible and even expected and selling could be a sure way to suffer a permanent loss of capital.

       v.            You always need to make back a higher percentage gain versus the percentage value of what you lost just to break even. A 50% loss requires a 100% gain to recover back to your starting point. This is because your portfolio value after a loss is always smaller than what your portfolio value was before the loss.

     vi.            A commonly touted piece of investment advice is NOT to try and time markets. This is true of trying to trade your long-term portfolio for short-term market fluctuations but you should be sensitive to committing new lump-sum (large once-off payments) investments following periods of strong market gains, particularly in equity markets. Despite an asset class offering a healthy long-term average return, you can suffer very heavy losses over the short-term, which can dent your enthusiasm for investing.

    vii.            Retirement plans will usually carry large exposures to shares or equities. Retirement funds are long term investments and shares typically deliver the best long term average returns, so you want exposure to this asset class to maximise the value of your retirement savings. But retirement plans will usually reduce exposure to equities the closer you get to retirement – life cycle planning. This is because equities can suffer large falls over short time periods and may take some time to recover. You want to minimise the chance of loss of capital the closer to retirement you get, so you reduce exposure to the assets that could potentially do this.

These concepts are all fairly easy to understand and most are common sense. Unfortunately all too frequently when faced with sharp declines in the value of our funds, we tend to  lose the ability to apply common sense and to think rationally.  By having a strategy that you are confident in and that you understand, you are far more likely to successfully manage your expectations and your emotions when the inevitable downturn in the cycle comes around.  

 Please contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.

Anyone who has ever entered into a discussion with me about investing (whether as a client or innocent bystander) will know that I feel very strongly about the costs associated with accessing investments and financial advice or products in general. I am passionate about not paying for a service I do not need or overpaying for a service that I do need.

The cost of actively managed funds can be exorbitant especially when the active manager struggles to outperform the market inclusive of the fees. Frequently it is in fact the fees that cause active managers to underperform the benchmark index and or passive investment funds. When you add on advice fees, and although less prevalent these days, initial fees, you have little hope of achieving real growth in your assets even if you take on higher risk assets to achieve higher returns.

The fact that there are advisors in today’s industry that charge an initial fee plus an annual ‘advice’ fee is both saddening and annoying when they do not actually provide any ongoing input into the investment process. I get especially annoyed when this happens on cash or money market investments! The winds of change are blowing however. Industry participants are changing their offering and regulatory and statutory improvements are in some ways forcing more ethical behaviour. It is now possible to access investments in a far more cost efficient manner, thereby increasing your chances of achieving your financial ambitions if you know where to look.

But before I dive headlong into another rant about fees (plenty of time for that), there is another hidden cost that most investors never even consider.  It is not the job of an asset manager nor even FAIS and all the regulations to highlight this cost to you but it can have a very heavy impact on the success or failure of your financial plan. I am talking about opportunity cost.

DEFINITION : OPPORTUNITY COST – The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. (Source: Investopedia)

It’s a simple concept to grasp and many of us already put it into practice in one form or another on a daily basis. However it often remains just a concept or a theory when it comes to the true impact on your financial well being. So let us use a real life example in the hope that the impact can hit home a little harder and that your future decisions will be made with a deeper understanding of the true cost and impact on your financial well being.

A client opted to go on a skiing holiday in February of this year. She pointed out that it was a once-in-a-lifetime spoil and since she had been so diligent in her savings over the past year she felt justified in the decision. A little look at our Opportunity Cost calculator* gives us an idea of the long-term impact of this decision.

The budget for the trip was set at R30 000.00 which is not bad for a week-long trip of that nature. Unfortunately the trip was only funded using cash of R10 000.00 while the remaining R20 000.00 had to be funded using an unsecured loan which is one of the costlier forms of borrowing. In this case the rate charged was 24% per annum. From her current budget the client calculated that she was able to put R1500.00 per month aside as payment on this loan.

From Figure 1 we can see that the R20 000.00 loan would be paid off in approximately 1.44 years or 17 months on the terms outlined above. The actual cost of the trip after the finance or loan repayments are taken into account is actually R35 953.01. (Almost 20% higher than originally budgeted).

But now if we assume she had foregone her trip altogether and committed that money to a savings account what would she have as cash in the bank after the 17 months?

Assuming she was able to achieve a 4.3% (not an unreasonable assumption) annual return she would have accumulated a total of R37 949.94.

This figure is made up of the original R10 000.00 plus approximately 17 months of additional R1 500.00 contributions and interest income of almost R2 000.00 – a hefty opportunity cost on its own.

But what if she was now to take this R37 949.94 (we ignore tax on the income in the spreadsheet) and invest it into her long term retirement annuity?

If she was to earn an average return of 9% a year for the next 25 years on this money it would equate to additional retirement savings of R 327 245.41. In today’s terms that is a whopping R76 247.73 OPPORTUNITY COST of going on that holiday!

Now before you jump down my throat about how boring life would be if we never did anything spontaneous and if my client were to die before retirement then surely the skiing trip would have been worth it – I hear you! I know on our deathbeds the size of our pension pot will be dwarfed into insignificance by the question of whether we really lived life to the full or not.

But successful financial planning should be about finding a balance in your life between living in the present and planning for the future. A successful financial future is the function of tough choices today, forward looking decision making and fighting the urge of instant gratification each and every day.

My mother used to tell us when we wanted to buy a motorbike that we should visit the hospital and see bike accident victims firsthand before making a final decision! Using that logic there are plenty of examples of pensioners out there who simply cannot meet their daily expenses – you need not look far to see the trauma of financial distress in ones ‘golden’ years. The low self esteem brought on by feeling unwanted in the work place, unable to provide for yourself and being a  burden on those who love you is soul destroying. All I ask is that you consider the opportunity cost of your spending habits today and give yourself a fighting chance of a future free from financial distress.  

*If you would like a copy of White Investment’s Personal Finance Kit spreadsheets simply send us an e-mail at info@whiteinvestments.co.za

 Please contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.

My daily monitoring of market news and headlines is throwing out a couple of signals that remind me a little of the complacency that existed in financial markets pre-crisis. 

A steady stream of articles articulate how the credit or corporate bond markets are absorbing new supply or issuance by the bucket load and in the higher risk tranches. The hunt for yield is once again overshadowing the obvious question of whether yields adequately compensate investors for the inherent credit risk that exists in the market.

I also noted an interesting snippet in the FT the other week suggesting that a private equity group is seeking to publically list a business called Countrywide- a real estate company in the UK. The reason this stands out for me is that Countrywide is a company who came to market with a new high yield bond deal right at the peak of the high yield boom in 2007. The deal proved to be great timing for the private equity holders who basically levered up a housing related business and extracted their equity capital just before the US housing market imploded. Management and equity owners suggested at the new issue roadshow that this business was ‘recession-proof’ because real estate agents make money for selling houses regardless of whether the prices are rising or falling. It was a good example of the danger of placing much reliance on management forecasts given the inherent bias that exists.  Suffice to say bond holders did not fare very well through that bond deal. The private equity partners (not entirely the same ownership structure) are now seeking to offload their equity stake via a public listing on the London Stock Exchange. The private equity partners have agreed not to offload any of their stake until six months have lapsed. Excuse the scepticism but I hazard a guess they are not seeking to exit the business because they think the prospect for the next few years is attractive and they want to share the upside.  The successful timing of these deals is not  predicated on being able to predict the future but rather sticking to a strategy and utilising the demand within the market to achieve their desired outcomes.

Finally, I see that last week Goldman Sachs and Morgan Stanley, two of the largest American investment firms, upgraded their forecasts for where the S&P 500 will end 2013.  They have upgraded their return expectations by about 12% from previous forecasts and it’s worth noting the S&P 500 is already up about 17% year-to-date and trading at multi-year highs again.  I wonder if this is more of a capitulation rather than a conviction forecast.

Not all forecasting and analysis is mired by hidden agendas and misaligned stakeholder interests however. The accuracy of forecasting, even by well intentioned and experienced professionals, can be wholly misleading as the following anecdote illustrates.

While thinking back to the Countrywide bond deal all those years ago I was reminded of the time in early 2007 when I had to do a presentation on the greatest risks facing bond investors. My firm had an incredibly intelligent economist who covered the US economy for us. He was hugely experienced and, in my opinion, well balanced in his process. I went to him and asked about some of the warning signs I should cover in my outlook segment. When we got to the topic of housing and house prices in the US, we were able to relatively quickly dispel this as an area for major concern as far as any negative impact on the economy was concerned. In short, he said, we need not worry about sub-prime lending which was already receiving lots of attention (somewhat like the unsecured lending is doing today in South Africa).  I will never forget the logic of his explanation and analysis which I think useful to outline here again to illustrate just how wrong the professionals can be.

Subprime Mortgages were at the very low end of the lending spectrum or riskiest form of mortgage lending. It was the largest growing area as everyone wanted to join in on the boom in house prices and lever their ability to create wealth. But subprime lending accounted for only 10% of the entire mortgage lending market. Since home loans or mortgages are by definition backed by the physical asset or property, even if home owners in this higher risk category did start to default on their loans then the recovery rate would be somewhere around the 50% mark. If I remember correctly he mentioned that housing contributed about 7% to the US economy so even under the worst case scenario – a complete collapse of the sub-prime mortgage market – the impact on US GDP would be around -0.35%*. With trend US GDP growth of about 3% at that stage, this was hardly a major concern.

Fast forward a few months and we now know that the subprime scenario played out in a very different fashion. Through all sorts of financial innovations (read leverage) and the support of rating agencies ascribing AAA credit ratings to what we now understand was toxic debt, we landed up with significantly far wider reaching costs and consequences of the subprime collapse. In fact it resulted in the near failure of the financial system as we know it with high profile casualties like Lehman Brothers, Bear Stearns, and the bail-outs of AIG and General Motors to name but a few.

To the best of my knowledge, no one has a crystal ball that enhances their ability to predict the future. Despite  this fact, you rarely pick up a newspaper, trade magazine or analyst report that does not attempt to in some way forecast the level of GDP growth, index returns or asset prices over a relatively short time horizon. This is not the fault of the financial services industry alone –  I can say from firsthand experience that fund managers are constantly asked to predict returns for their asset class and are often measured on quarterly, if not monthly, performance statistics by the very people who employ them to manage their investments for the ‘long-term’.

History can however be useful to provide guidance (but not guarantees) on what the future may   hold. If over the last 100 years real returns from equity markets have outperformed cash investments then one could reasonably expect them to continue to do so over the long term. That is not to say they will necessarily do so over the next 12 to 36 months though. Similarly, if a company has produced steady earnings growth and dividends payouts over the last 10 years, barring any major industry changes or loss of competitive advantage, we could reasonably expect them to continue to deliver.  

Understanding the difference between predicting the future and using past experience to guide your future actions can be very helpful indeed.  There is no room for complacency and we should monitor markets for signs of history repeating itself. The purpose is not to make a prediction but merely to prepare ourselves for the possibility of a short-term shift in momentum and to ensure that we do not try and adjust our long term strategy as a result of short-term shocks. You need to be sure that you are happy with your investment strategy on an ongoing basis.

If rebalancing is required as a result of the strong run up in equity markets, now is the time to adjust portfolio positions and not after a 20% or more correction!

*Workings of an overly simplistic but nonetheless enlightening example

 Lets say GDP is represented by a nice round $100.

So the mortgage market accounted for 7% of GDP or $7.

And we said subprime only accounted for 10% of the mortgage market so $0.70 of GDP.

If the entire subprime market defaulted and we recovered 50% on foreclosure sales then we would only suffer a loss of $0.35 or 0.35% of GDP.

Please note this write-up does not constitute advice. Contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.

If you ever needed proof that economic indicators are very poor predictors of market returns then you need to look no further than the last twelve months or so. Despite GDP growth rates indicating slowing economies in the US, UK and Europe (including Germany), all risk assets are trading at multi-year highs.

 Why? The rally is largely the result of some of the most unusual steps to support a financial system in the history of the modern world. If, at any time in the past four or five years, there were signs of fragility, the world’s governments and central banks charged in with seemingly endless amounts of money to support the system.  Markets are supposed to be forward looking and so logically these measures, which are designed to stave off disaster, have been rewarded by improved sentiment and therefore higher asset prices.

Akin to the famous debate about which came first – the chicken or the egg – we can also debate whether the recovery is purely the effect of the unusual monetary and fiscal stimulus measures or whether the recovery can ultimately create the environment for us to survive the imbalances caused by these unusual stimulus measures.  Is the pain of past excesses ultimately unavoidable and is this a harsh lesson we will learn as stimulus measures fail to be sustained indefinitely?

I would suggest current asset prices imply that the recovery is sustainable and that the excesses can be managed as these stimulus measures are withdrawn. I remain scepticle of this goldilocks-type-scenario playing out but acknowledge that we can consider the same evidence and come to opposing conclusions and portfolio positions.

THE BULL CASE:

The balance sheet or the financial health of companies and households is generally much stronger.  This is perfectly true in many cases – default rates are lower and corporate and household deleveraging has taken place as money has been injected into the system through central bank interventions and policy decisions. Interest rates are at the lowest levels on record, making servicing debt a much easier proposition from available income. Things are so good that some companies like APPLE are under pressure to return some of their cash pile to investors because cash makes up something like 30% of the market cap of the company. Sounds quite rosy.

Corporate earnings are strong and around 72% of S&P500 firms have beaten estimates in the latest quarterly review. This is another very positive sign that goes some way to justifying the recent equity market gains. Paying more for shares in companies you expect to receive a higher earnings yield from makes sense.

Economic data points are indicating a recovery. Again this is true in many cases. Forward looking indicators like the PMI services data out of the UK and Europe last week have moved above 50, indicating expansion. Consumer and business sentiment surveys are also generally more positive on future prospects. China is apparently successfully navigating its way to a soft landing and will once again be a huge driver of global economic growth.

Equity markets are one of the few assets classes offering real returns these days. For savers and those already in retirement, the idea of yet another year of negative real returns from their bond and cash positions is getting untenable. The pressure to take on risk via equities is growing as nothing else is delivering the required returns. Equities, while potentially not attractive on an absolute basis, are attractive relative to all the other options out there. Money is flowing into equities and the Bloomberg survey taken at Davos in January, revealed that 66% of respondents expect to add to their equity holdings in the next 6 months.

THE BEAR CASE:

The balance sheets or the financial health of companies and households is generally much stronger.  APPLE is not deploying their large cash reserves into new investments, which could be a sign that they are not that confident about the prospects for the future. Lots of uncertainty over the fiscal cliff and US policy initiatives may be to blame. On the other side of the Atlantic last week we saw that PEUGOT may need the support of the French government to survive – Obviously not all is quite so rosy out there.

It is also worth noting that the corporate deleveraging that has taken place is not due to the problems having been resolved. A lot of the debt excesses that led to the financial crisis have simply been moved to the Government’s balance sheet and will still need to be addressed in the fullness of time.

Corporate earnings are strong and around 72% of S&P500 firms have beaten estimates in the latest quarterly review.  This kind of statistic can be meaningless. Earnings ‘beats’ are frequently measured against estimates that have already been revised lower. What if I were to tell you at the start of the year that your salary would be R100 000.00, but by March I estimate that it will only be R98 000.00 and by September I have revised my guidance to R85 000.00 for the year. Then, at the end of the December, you receive your final pay-check which shows that your total income for the year was R90 000.00. Do you go out and celebrate because it was better than the 85 grand last estimated or do you feel aggrieved that it was 10% less than I initially told you at the start of the year?

Economic data points are indicating a recovery. You can pick economic data points to support or refute any theory if you really want to. In reality the reaction to single data releases is more an indicator of market sentiment rather than any actual statistical relevance. UK GDP for the fourth quarter fell -0.3% versus an expected fall of -0.1%; US GDP fell -0.1% versus an expectation for a rise; and Germany, Europe’s biggest economy, saw GDP fall by -0.5%. The US unemployment rate also ticked back up to 7.8% last month but the markets shrugged off all these negative data points and continued to rally.

Even if the positive news is sustainable and central banks have engineered a recovery, inflation will surely follow. The stimulus will have to be retracted at some point. Interest rates will have to go up, and money supply will need to be removed from the system. Can the real economy actually stand on its own without the support of central banks? How solid will real earnings remain and how healthy will balance sheets look when the inevitable process of ‘normalisation’ begins?

If the answer to any of these questions is uncertain, then any strong signs of recovery, accompanied by the likelihood of sharp gains in the inflation rate, could lead to a reduction in stimulus measures which in turn could be the catalyst for profit taking in risk assets.

Equity markets are one of the few assets classes offering real returns these days. This is the one bull case statement that I have sympathy with because it is a fact. However, having acknowledged that, it is not wise to chase returns on the basis of short-term market moves.  If equity markets are not your natural asset class, given your age or ability to take on risk, then I would strongly urge you not to capitulate and enter equity markets at these levels out of fear of another year of lowly returns elsewhere. Your investment strategy should be in place for the right reasons and making short term adjustments may seem right for the next 6 to 12 months but you could suffer significant falls in your capital value if equity markets give up some of their recent gains.

So what am I doing right now?

The funds I run with a long-term objective (my retirement savings and child’s education investments) will maintain their equity market exposures,despite  my misgivings over current valuations, as I expect equities to deliver the best real returns over time.

On the other hand, my trading strategies have a more short-term focus on capital preservation and are currently very heavily weighted in cash and equivalents. This has cost me when I compare my returns to equity markets in recent months but I am okay with that short-term. I remind myself that it is my strategy to protect this capital from downside risks and not to succumb to ‘what-if’ emotions.

Many may perceive my defensive position as being a bit chicken, but I remain concerned with the price of risk assets (equities and bonds) and the low level of volatility, given some of the major global uncertainties that still prevail. Added to which, I think if the recovery is sustained, central banks will have little option but to withdraw some of the stimulus measures and the equity markets may take this as a signal to sell given how the stimulus measures have driven up prices in recent years.

Please note this write-up does not constitute advice. Contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.

Source: Financial Times/www. ft.com as at 4 January 2013

They say a picture is worth a thousand words – this one has proven to be worth a few thousand Rand too.  

My godson, Steven, turned 10 years old in July of last year and other than being very proud of the young man he is growing into, he also has a valuable investment message for us, even at his young age. Steven’s time in this world overlaps quite nicely with the above graphic, which represents the price return of the South African JSE All Share Index over the last 10 years.

I mention Steven, as in lieu of purchasing a gift for his Christening, I put a couple of thousand rand into a passive SA Equity tracker fund for him in early 2003.

As of January 2013, Steven’s passive investment in the JSE All Share has grown by about 420% – this works out to around 18% each year for his 10 years. That is a brilliant real return which should make any investor very happy. This is even more impressive in the context of a South African equity market which has averaged a 12.5% return since 1900. (Source: Credit Suisse Global Investment Yearbook 2012)

With the benefit of hindsight, it seems to have been a no-brainer to have re-mortgaged the house and invested the proceeds into the SA equity market over this period. (Preferably in a heavily leveraged manner too if possible) However, without the advantage of hindsight or a crystal ball, accurately predicting or forecasting future market returns is improbable, if not impossible. Added to which, if we scrutinise this 10 year performance over shorter time periods, it becomes apparent that there is typically a lot of ‘noise’ that provides investors with plenty of opportunity to complicate matters. Most of the time this complication is achieved by trying to time the market, usually heavily under the influence of emotional duress.   

For example, by the time the market peaked in May 2008 at 32700, Steven’s investment would have gained 320%, representing an annualised return of 33% a year. Sheer genius results even for investors of the calibre of Warren Buffet. This would have been a great time to book profits in hindsight, especially since we now know that we were on the cusp of the Global Financial Crisis (GFC) and the collapse of Lehman Brothers late in 2008. In reality however, if Steven was trading rather than investing, he would most likely have booked a 100% gain sometime in 2006 as he had doubled his money and would have lost out on the additional returns or at least some of them.

From the peak in May 2008 to the trough in November 2008, the JSE All Share index lost almost half of its value or 45%. The world as we knew it was ending.  Banks were literally collapsing, companies were unable to access any funding and the prospect for the future was as bleak as it had been during the Great Depression. I was working in London at the time and can vouch for the panic that dominated the actions of private clients, institutional clients and professional investors alike during this time. Many investors sold out at or near the lows as the carnage became too much to bear. Many of those who sold out then failed to re-enter the market on the uptick which means they exacerbated their position by failing to participate in the approximate 123% gain since 2008. If Steven was trading rather than investing how would he have fared facing these fluctuations? Probably not as well as we would like to believe.

Under a scenario of perfect market timing it is true that Steven could have sold at the high of around 32700 on the index in May 2008 and then reinvested at the lows of around 18000 in November of 2008. His returns today would have been closer to 843% or a whopping 25% annualised return over 10 years. I am not aware of a single investor or trader who managed to trade the crisis with that level of success.

The irrational behaviour we display as human beings when trying to time markets is based on what seems like a very rational thought process at the time. When markets have delivered strong returns, it is usually on the back of a recent period of strong earnings growth from companies, which translates into higher share prices.  This strong earnings growth gets extrapolated into the future and so we tend to expect equity returns to continue to power forward and are therefore more likely to be buyers at new market highs rather than sellers. Conversely, when markets are selling off, as during the 2008 period, we tend to also extrapolate these losses into the future and thus sell at or near market lows when everyone else has finally capitulated and are also selling.

These market inefficiencies are mostly caused by emotional-driven investing and are easy to identify in hindsight but nearly impossible to identify in the heat of the moment. We are therefore likely to continue to witness similar market swings in the future.

Personally when I look at the graph above, and consider the uncertain macro-economic environment in which firms currently have to operate, I feel a great sense of unease going into 2013. I would not be surprised to see a strong pull back from these levels and with my ‘Traders-hat’ on I would be tempted to lock in profits here and look to re-enter at cheaper levels.

Trading can certainly have its place in your financial plan – if you stayed invested in the S&P500 over the 9 years preceding the end of 2011 your price returns would have been close to zero, but there would have been huge fluctuations within that period. If you opt to go the trading route you must be clear about your objectives and you must operate within a defined and disciplined process to be successful. You must also accept that you will incur higher trading fees and be subject to more taxation as a result of your activity.

Steven, on the other hand, is an investor. He has held this investment throughout the 10 year period and will hopefully continue to do so for at least the next 8 to 10 years. Of course Steven has not actively been monitoring his investments over the entire period but I can assure you that he is aware of the existence of the investment and has a better understanding of the principles of investment as a result.

Steven has, perhaps somewhat inadvertently, displayed the characteristics integral to creating wealth that we as adults often battle to master – Patience, discipline and unemotional decision making. If Steven continues to display this attitude in his approach to investing as he grows older, his chances of creating real wealth or ‘striking it rich’ will be much improved.

Increase your chances of investment success:

Set a goal with a specific objective and time horizon.

Plan and implement a strategy to achieve that goal.

Make sure you decide upfront whether you are investing for the long term or actively trading under this strategy. Your activity will differ significantly under the two approaches.

If you’re an investor with a long term time horizon, try and avoid changing your strategy on the basis of emotional decisions in response to market fluctuations. The strategy is there to protect you from your emotions – remain focused on the long term.

Please note that this article does not constitute advice. If you would like to start investing for your future, consider partnering with White Investments who will help you identify a strategy for long-term success.

In September I wrote an article on potential income investing options. (Investing for Income -Sep 12) The opportunities for real  returns, or returns after being adjusted for  inflation, were slim at that time. There have been some significant moves since then, which warrant an update of the numbers.

Latest inflation rates (Year-on-Year)

Source: www.tradingeconomics.com as at December 2012 ex SA which is still Nov12 number.

Summary table of yields:

Source: *tradingeconomics.com, ** ft.com+moonstone, ^ wsj.com, ^^ wsj.com + investorintelligence.com, ~ft.com,~~ iShares ETF for US & UK, PropTrax ETF for SA Property. As at January 2012

The general trend indicates that inflation has picked up across the board, although we are still at relatively low levels for all countries on a historic basis. The significance of this is that, even if the absolute income yield on your investments had remained the same, the REAL YIELDS will have fallen further. Simplistically, your money would buy you less of the same goods as it had in September.

Yields on the various income options have not remained static however. If you have kept even half an eye on markets over the last four to five months you will know that risk appetite levels have risen. According to market commentators, this improved risk appetite is largely as a result of a decline in the headwinds or risks relating to the Euro crisis, US fiscal policy uncertainties and an improvement in Chinese economic data.

The asset classes in the table above have reacted in a fairly predictable fashion if we are indeed on a path to continued economic recovery. A long-term sustainable recovery would result in even higher inflation levels and eventually central banks will have to withdraw the unusual stimulus measures.  As hard as it is to believe right now, they will even have to start raising interest rates at some point in an attempt to control the potential for inflation to spike from here.

Cash & equivalents – Interest rates have remained static since September, as central bank actions remain focused on ensuring a recovery. Money market rates have begun to move higher, albeit marginally, which is what will happen as the market eventually prices in interest rate hikes.

Government Bonds – With the exception of SA, government bond yields have risen. Bonds are generally fixed rate instruments, so if investors anticipate a rise in inflation, and subsequently interest rates, they will try and sell their bonds before the fixed return is eroded. Bond prices will fall and yields will rise as a result. South Africa is a high yielding ‘emerging’ country and still relatively attractive to yield seeking investors in the developed world. SA bonds have remained in demand from international investors and yields have fallen slightly.

Corporate bonds – The fact that companies will tend to perform well as the economy recovers means that the greater appetite for risk assets is also evident in  ‘spread compression’ or lower yields in corporate bonds. None more evident than in European High Yield yields, which have fallen by almost 3.5% over the last few months. (Perhaps a little too complex for the current discussion but a rise in government bonds will partially offset a fall in corporate bond spreads as corporate bonds are priced off an underlying government bond.)

Equity – Dividend yields are, if anything, slightly lower too, which means the real yields from equities have fallen since September.  It makes sense that equity dividends yields are lower as stock prices have enjoyed a strong rally on the back of improved optimism. The prices we are paying to gain access to income from equities is higher and therefore the yield will be lower.

Property – I did not include property yields in the initial analysis (was Total Return) but this time around I have used the yield on respective country exchange traded funds (ETF’s) to give an indication of the yields available in the asset class. The rally in property assets has continued and the yields from these funds have fallen over the time period.

Please note this write-up does not constitute advice. Contact White Investments if you would like to learn more about your income investment options, both domestically and offshore.