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The second secret of long-term investment return

30 November 2007 Gareth Stokes

As a financial adviser, one of the most compelling illustrations you can provide your client to convince them of the benefits of regular savings is the impact of compound interest. Compound interest, says Wikipedia “is the concept of adding accumulated in

If the investor in this example had elected to receive the monthly interest the situation would be entirely different. After a decade, this investor would receive the principle amount of R10 000 plus interest of R9 500 (a fixed amount of R79.17 each month) for a total of R19 500. This investor sacrifices R6 260.55 by not compounding his interest.

Compounding is not limited to interest only

Unit trust investors will know that these products reinvest all income earned, including interest from cash holdings and dividends from equity investments. Dividends are simply the (usually voluntary) distribution of company earnings to shareholders. Thus instead of receiving dividends when they are earned, these dividends are simply applied to purchase more units in the particular collective investment.

What caught our eye recently was an article by Matthew de Wet, Head of Investments at Nedgroup Investments. De Wet was commenting on the range of capital guarantee investments being offered at the moment. He did not single out a particular product – but we’ve noticed a few of the big banks offering them. The sales pitch is simple: invest a principle amount with the bank for a minimum of three years and the bank will guarantee your capital. Fees or penalties will apply to early withdrawals. And you will benefit from the growth in a particular benchmark (usually a stock market index) – though this growth will be capped to a certain maximum.

For example: you invest R10 000 in ABC Bank’s Capital Guarantee Fund which is linked to the Top 40 Index. ABC Bank guarantees your capital and caps growth to 25% per annum. If the bank manages the investment well and achieves in excess of 25% per annum, they keep the excess and you get the 25%. But how does the bank make money if it cannot beat the upper target?

Forget about the explicit costs – there are subtler forces at work

De Wet notes that “The costs of these guarantees vary from easily quantifiable explicit costs (usually stated as an annual percentage), to the lesser-understood implicit costs.” And here’s the catch. According to De Wet, “A common approach to financing these guarantees is through foregoing the dividend stream of the underlying equities.” So how can the investor determine if the foregoing of dividends is a fair sacrifice for guaranteed capital return?

De Wet answers this question with a concrete example. Consider an investment of R100 in the South African equity market in 1961. The investment is left untouched until 2006. South African equities provided an annual return of 18.9% over this 45-year period. The R100 investment soars to R283 489 over that time – benefiting from capital growth and the reinvestment of dividends.

Were one to strip the dividends out of the equation, the picture becomes totally different. SA equities only managed 13.6% per annum with dividends stripped out, meaning the R100 principle would have grown to a disappointing R35 479 after 45-years. And that equates to an opportunity cost (of foregoing the dividend) of 87%! Over an average 5-year rolling period this opportunity costs falls to 21%. De Wet noted that the average dividend yield from the SA equity market in the 1970s stood at between 4% and 5%. With today’s average between 2% and 3% the opportunity cost will be slightly less – but still significant.

Understand the costs on innovative products

This example clearly indicates how ‘hidden’ fees can impact an investment performance. And it is quite easy to miss such charges in the excitement generated by the investment company’s guarantee. Ever since South Africa’s furniture favourite “Morkels, your 2-year guarantee store” South African’s have been obsessed with the word ‘guarantee’. We have seen any number of investment scams that offer a totally untenable guarantee. They might ‘guarantee’ returns of 35% an annum with absolutely no hope of honouring the promise. Fortunately the sensible investor will turn such ‘opportunities’ down without a moments hesitation.

It is more difficult when the guarantee appears reasonable and is carried by credible financial institution. A reputable investment firm will honour the intention – but as demonstrated will make sure they are handsomely compensated for carrying the guarantee. De Wet implores investors to make sure that “explicit and implicit costs [are] fully understood, and evaluated relative to the guarantee offered, before making investment decisions.

Editor’s thoughts:
When we first saw one of these capital guarantee products we thought it would be an ideal investment, especially against the backdrop of a shaky global equity market. De Wet’s article opened our eyes to the possible pitfalls of such an investment. Have you invested in capital guarantee products, and with hindsight, what have you felt about the outcome of such investments? Post your comment online or send an email to gareth@fanews.co.za  

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