When there's no such thing as a guarantee with investment products

A guarantee is generally an assurance that sets us at ease when choosing how to spend our money. Most of us won’t mind paying a little more for a washing machine or new flat-screen television that comes standard with a warranty, for example. But what if all guarantees are not quite equally attractive?

Unfortunately, this is often the case with guaranteed investment products, which guarantee a predetermined, after-tax return over a specified investment period of usually five years. Offered in a policy structure, guaranteed products therefore lock you into the policy for the agreed period of time in exchange for delivering the growth as promised at the outset of the investment.

However, consider that the average return offered by local guaranteed products for the next five years is 5.8%¹. With the CPI inflation rate currently sitting at 5.3%, this effectively means that guaranteed products will, on average, deliver a real return of 0.5% assuming inflation remains flat – leaving you only marginally better off in real terms than you were when you purchased your policies. Should we see inflation rise to above 6%, investors currently committed to the same five-year guaranteed product policies will have made a loss in real terms when these policies reach maturity.

At the same time, you would have missed out on other opportunities to generate real returns, as a lack of market exposure caps upside growth potential and means that you are unable to take advantage of any favourable market conditions.

A third consideration is the fact that guaranteed products are linked to a predetermined investment term, which means that you are locked into that policy for a set period of time. And finally, the guarantee you receive – albeit an imperfect one – normally comes at an additional cost.

Inflation-linked products could be considered an alternative to guaranteed products. These products, which aim to provide growth that either equals or outpaces inflation, are invested in the equity market to varying degrees and are actively managed to achieve their stated benchmarks.

Although more conservative investors may instinctively shy away from equities due to the perceived volatility of the asset class, a clearer picture emerges when looking back at historic market returns. Let’s consider the annualised performance of the ALSI, the Johannesburg Stock Exchange’s All Share Index, since 1974 over rolling five-year periods – the standard term of a guaranteed product.
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As we can see from the chart above, the ALSI – the broadest measure of South African stock performance – has not once generated a negative rolling five-year return in over 37 years. In fact, the lowest rolling five-year return recorded over this period was 3.5%. So had you invested solely in the South African stock market for any consecutive five years since 1974, you would never have made an outright loss. You would also have been able to generate a return of anywhere up to 46.4% (and an average return of almost 20%), giving you huge upside potential on the average guaranteed product return. From this point of view, the equity market is not nearly as daunting as investors may think.

This performance is of course not guaranteed, but does put long term investing into perspective.

It should also be remembered that the returns highlighted above would have been earned on pure equity investments. However, inflation-linked products can be invested in a number of different asset classes. A more conservative investor would therefore be able to invest in an inflation-linked product with a balanced mandate. This gives the added safety of greater diversification and lower volatility while the product still seeks to generate real returns. Through active management, inflation-linked products further hold the potential to outperform their inflation-linked benchmarks, which means that prospective returns are never capped.

This is evident when considering the annualised rolling five-year returns of four quality inflation-linked funds with balanced mandates, all of which are available on the PPS Investments platform. For our purposes, we’ve compared the performance of these products to a benchmark return of CPI+ 4%:

When taking into account that inflation-linked funds are not subject to fixed investment terms, quality inflation-linked funds therefore hold the potential to offer a significantly better proposition than guaranteed products.

So Investors should assess the benefits as well the detractors of guaranteed products carefully before committing to a long-term decision. A well-constructed portfolio of inflation-linked funds offers a great alternative to these products and should be discussed with your financial intermediary when evaluating the investment choices available to you.

¹ Moonstone Information Refinery (Pty) Ltd, Investment Rates 19 September 2011