How to beat inflation in a low return investment environment

Despite expectations of lower returns from traditional assets over the next several years, a combination of active fund management, lower fees and increased exposure to alternative assets can contribute to beating inflation and maintaining the purchasing

Tamas Kulcsar, Head of Manager Research at Novare Actuaries & Consultants, said that products developed over recent years to target inflation-plus returns have been mandated to invest in traditional asset classes, with capital allocated to equities, property, bonds and cash to reach the required return objective.

“The past 10 years were pretty easy for fund managers as all of these asset classes generated returns well in excess of inflation thanks to a bull market in equities, a declining interest rate environment, which is good for bonds, and reasonable economic fundamentals that supported property. Even money market funds outperformed inflation due to high interest rates in the early 2000s.

“More recently however, investors have started to question the ability of traditional asset classes to deliver real returns against the backdrop of an elevated domestic equity market, record low bond yields, and a domestic property market that returned close to 40% in the past year and in excess of 25% a year over the past decade.

“In a low return environment financial advisers and trustees need to think outside the box to protect and grow wealth for their clients. We believe a combination of active management, lower fees and an increased allocation to alternative investments can contribute to meaningful alpha creation in a low return world.”

Active management doesn’t simply mean allocating money to an active portfolio manager and should include taking money offshore. “There are times when international assets are more attractive due to deteriorating domestic fundamentals and disappointing company earnings. A weak rand should not be seen as a reason not to invest offshore if the expected returns from foreign markets compensate for the exchange rate risk,” said Kulcsar.

Reduced fees are another way to create alpha, and investors should question the fees charged by active managers.

Said Kulcsar: “A 1% annual fee may seem reasonable when a portfolio is returning 15% a year, but when expected returns from an asset class drop to below 10%, the picture changes. As advocates of active investing, we prefer to only pay for excess returns and, where possible, get reimbursed for underperformance either through a management fee discount, a lower annual base fee or a simple reimbursement of performance fees charged.

“These arguably more equitable fee models are popular in international markets, but are yet to be adopted by the mainstream asset management industry in South Africa.”

The third way to beat inflation is to incorporate alternative investments into a portfolio. Hedge funds, unlisted debt, inflation-linked bonds, private equity and protected equity can all be used to reduce a portfolio’s dependence on the returns of listed equity and bond markets.

“Most of these investments generate returns with a low correlation to traditional markets. They can provide stability to a portfolio in times of market volatility, as well as excess returns in a low return world,” said Kulcsar.