2017: Time to invest in an alternative reality?

Last year was not a good one for equity investors. Including dividends, the FTSE/JSE returned just 2.6%.

In rand terms, offshore returns were even poorer. The MSCI World Index was down 4.6% in local currency.

There is also little indication that this is likely to reverse over the next 12 months. The high levels of market uncertainty are making it very difficult to know where to look for returns.

“Coming into 2017, things have been significantly more uncertain than they have been over the last five or six years,” says Investec's Brian McMillan. “Political and economic tension has been heightened following the Brexit vote and the election of Donald Trump, and that makes it very difficult for investors.”

Even if markets do turn positive this year, the expectation is that equity returns will be below the long-term average.

“We've had a long bull run and now equities, both locally and internationally are looking pretty expensive,” McMillan says. “If you look for value, there is not a lot out there.”

Alternative reality

One of the interesting things to come out of last year was, however, the performance of equity products offering alternative exposures. Certain local smart beta index trackers excelled.

For example, the CoreShares Divitrax, which tracks the S&P South Africa Dividend Aristocrats Index, gained 17.13% over the year, while the Satrix Rafi 40, which tracks the FTSE/JSE Rafi 40 Index, also performed strongly, finishing the year 18.97% higher.

This shows that there is the chance for investors to find performance in products that don't align closely to the broad market index. However, Zack Bezuidenhout from S&P Dow Jones Indices, says that while these smart beta products do offer alternative sources of return, investors need to consider their options carefully.

“What we noticed last year is that the top performers from 2015 were the worst performers of 2016, such as momentum strategies,” Bezuidenhout says. “While value strategies, which have performed poorly for a couple of years, did well.”

He therefore suggests that investors consider multi-factor strategies that have diversified sources of risk and return.

“Blending these factors provides better protection,” Bezuidenhout explains. “For example, a combination of momentum and value works better than just using one of the two.”

He also recommends considering strategies that cap the exposure that they can have to any one stock, particularly in South Africa.

“Capping certain stocks at 10% means that you are not over-exposed to a single company like Naspers, which in the normal market cap index is currently sitting at around 20%,” says Bezuidenhout. “That makes investors very vulnerable.”

Structured products

Another appealing option for investors is to use structured products that offer a guaranteed pay-off profile. These products usually multiply any market gains up to a certain point, while also offering protection against loss.

“I think this year a lot of people will be looking at protecting their capital, and that's one of the main reasons to invest in structured products,” says Investec's McMillan. “Downside risk is high at the moment, and that means that it’s vital to have a level of capital protection.”

The chance to see increased returns is also appealing, given how muted expectations are.

“Getting very high real returns for marginal increases in the market is attractive right now,” McMillan says. “A geared upside is great when you are not expecting a very high nominal return.”

For example, the Investec USD S&P 500 Digital Plus product, which is due to mature in April, has gained a level of 73,76% since inception. Investors, therefore, not only have the certainty of knowing that their capital is protected, they can also see greater upside if markets are positive.

Investors do need to be aware that when using structured products they will be giving up some liquidity, as they generally need to be held over three to five years for the full benefit to be realised. In the current environment, however, this may be less of a concern than the benefits derived from being invested in a product with a predefined return.

“Structured products are not trading instruments,” McMillan says. “They are long-term investments that provide investors with defined levels of capital protection and upside to suit their own risk and return appetite. And in a year that is already seeing most analysts scratching their heads, investors would be wise to allocate some assets that provide a level certainty.”