Longevity and low returns – a deadly combination for investors

Frederick White, co-manager of the Sanlam Investment Management (SIM) Balanced Fund

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.’