03 N o v e m b e r V o l u m e 9 33 Avoid cash-trapped investing Written by: Luke McMahon, Research & Investment Analyst at Glacier by Sanlam

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 03 N o v e m b e r V o l u m e 9 33 Avoid cash-trapped investing Written by: Luke McMahon, Research & Investment Analyst at Glacier by Sanlam Investing is a journey Many investment gurus and professionals who have major skin-in-the-game will tell you that successful investing is a journey, not a one-time event, and you'll need to prepare yourself as if you were going on a long trip. Identifying and clarifying investment objectives and time horizons are critical. Also, learning about your personality as an investor, e.g. your risk tolerance, requires a fair amount of time and patience, not to mention the trial and error which will help craft your investment behaviour. Capital market history, especially in developed countries, is filled with many instances of case study events which are rich with investment lessons. South Africa s (SA s) capital market is still relatively young in comparison to many developed markets such as those in the United States (US), United Kingdom, Japan and Europe. However, there have been a number of significant market events which have produced impressionable learning curves for SA investors. This has been enough to show that capital markets can be relentless and unforgiving if you are caught on the wrong side of a position, yet rewarding and resilient enough to show that markets can bounce back stronger and further than a brutal market crash. Therefore one of the fundamental lessons for most investors to learn is the importance of patience, especially in the face of adverse market conditions. I would like to illustrate the importance of this lesson with a real life example. Early last year a family member of mine decided to invest a sizeable amount of his discretionary savings in a high risk asset class, mind you the timing of this investment was made toward the end of the first quarter shortly after China s main stock market flirted with bear-market territory and other major equity markets such as Japan and the US were getting beaten down as well, along with the price of Brent crude oil plummeting to a historic low of $27/barrel. One would think that this was an ideal time to buy into a high risk asset as it was at a low point. Given hindsight, it really was a good entry point. However, subsequent market volatility, brought about by a plethora of political events (Brexit, etc.) throughout 2016, saw this family member s investment take a knock and by year s end he decided that he could no longer stomach the volatility, especially after the US election, and moved the remainder of the investment into a money Glacier Financial Solutions (Pty) Ltd, l A member of the Sanlam Group Private Bag X5 l Tyger Valley 7536 l client.services@glacier.co.za Tel l Fax l Web Reg No 1999/025360/07 l Licensed Financial Services Provider This document is intended for use by intermediaries. The information contained in this document has been recorded and arrived at by Glacier Financial Solutions (Pty) Ltd in good faith and from sources believed to be reliable, but no representation or warranty, expressed or implied, is made as to its accuracy, completeness or correctness. The information is provided for information purposes only and to assist the financial intermediary to submit an investment proposal to the client and should not be construed as the rendering of investment advice to clients. Page 1

2 market account at a large bank. With some time having passed, and almost a year later, his investment at the bank has grown by roughly 7%, whereby his capital can be regarded as safe and secure. However, had he not withdrawn his initial high risk investment, the gain on the initial capital would have been approximately 53% as at 31 October Defining cash-trapped investing The above example speaks to the very essence of the dilemma faced by investors this year given the All Share s meagre 2016 return of 2.68%, in that it highlights the pitfall of abruptly changing an investment strategy before allowing the particular investment time-in-the-market, and de-risking to a cash position in fear of market volatility and loss of capital. The cash-trap is essentially the opportunity cost of the gains an investment could have achieved had it been allowed to work and compound over a meaningful period of time, instead of being diverted to a cash investment. No doubt, the experience that my family member had is a story which many investors can relate to, especially those that have been invested in the SA equity market over the last few years. Are the golden years over for SA investors? For the best part of the last nine years since the Global Financial Crisis (GFC), SA investors were accustomed to receiving double digit annualised returns from local equity. A brief look at some of the figures show that local equity has since the 1 st of January 2009, up until 31 st October 2017, provided an annualised return of 15.42% on a total return basis. Subsequently, we are currently in the second longest bull market in history. However, upon closer inspection of market returns, it can be seen that over the same time period, up until 30 June 2014, investors actually experienced a staggering annualised return of 20.37%. This is all fair and well in retrospect but for many investors that have been heavily exposed to SA equity over the last three and a half years, it has seemed that those golden years are over. Having dealt with many client queries about where markets are headed and concerns over whether their investments will provide sufficient growth for them to even draw an income, further inspection to ascertain what the actual client experience has been since 30 June 2014 was warranted. The insights gathered are quite scary, as per figure 1 below. From the period 30 June 2014 to the end of last year s calendar year, local equity only provided a meagre annualised 2.75% on a total return basis. This is highly significant since the majority of SA investors are exposed to SA equity in their portfolios. Statistics from the Association for Savings and Investment South Africa (ASISA) as at the end of Q reveal that the majority of SA s retail Collective Investment Scheme (CIS) investors are invested in General Equity and SA Multi-Asset High Equity (75% equity) funds which are heavily weighted to SA equity % p.a % p.a. 01 January June December 2016 Figure 1: SA Equity JSE All Share Index TR (J203T) Source: IRESS & Morningstar Page 2

3 No need for hindsight They say hindsight is the perfect sight. Well the same notion holds true for investing. However, if one is able to remain disciplined enough when following a well thought-out investment plan, hindsight need not be a major concern for investors. This is clearly illustrated in 2016 which was a difficult year for investors both locally and globally. Those looking for growth from traditional risk investments last year would have been hard-pressed to look at their calendar year performance as equities severely underperformed cash, as depicted in figure 2 below. For most investors saving toward retirement or actual retirees requiring high growth due to not having sufficient savings, 2016 would have been a year of pain. Especially since most of these portfolios would have had a higher tilt toward SA equity. Not to mention, politics became a prevalent force to contend with in capital markets last year, and would hardly have instilled confidence to be invested in a time when capital risk was not being rewarded with commensurate returns CUMULATIVE RETURN - SA EQUITY VS CASH FTSE/JSE All Share TR ZAR STeFI Composite ZAR Figure 2: SA Equity vs Cash Cumulative Return 2016 Source: Morningstar Subsequently, with many SA investors having experienced a difficult 2016 calendar year and extreme market volatility due to the unstable local and global political climate, many SA retail investors opted to make a critical decision and increase their cash holdings within their portfolios. This is confirmed by ASISA statistics which recorded the highest net inflows over Q1 (R 11.1 billion) and Q2 (R 20.6 billion) in 2017 going to SA interest bearing, particularly money market and income funds. Also, there is no surprise that net inflows for SA Equity funds in the last quarter of 2016 were negative (-R 637 million). Following a difficult 2016 calendar year, many investors were not sure what to expect in To the surprise of many, equity markets around the world rallied to new highs amid strong corporate earnings and synchronised global growth in major economies. As a result, the second longest bull market in history seems to still have some steam behind it. Locally, SA investors who remained invested in equity instead of switching to cash would have benefitted significantly from the strong rebound. This is quite evident in the 13.3% outperformance of SA equity over SA cash as at 31 October 2017 as depicted in figure 3 below. Subsequently an investor that was heavily invested in general equity in 2016 and then switched just before 2017 would have experienced a twofold drawback to their portfolio, in the form of low returns in 2016 and the opportunity cost (missed excess return) of the strong equity recovery in Page 3

4 +13.3% Excess Return Figure 3: SA Equity vs SA Cash Cumulative Return 2017 YTD Source: Morningstar A working example Up to this point we have discussed the issue of cash-trapped investing relative to only one other asset class, equity. However, since the majority (51%) of SA retail CIS investors are invested in SA multi-asset portfolios it would be beneficial to see how cash-trapped investing may affect an actual portfolio. For illustration purposes we will use a risk-profiled model CIS portfolio constructed by the Glacier Research team. Glacier Research Risk Profiled Core Model: *Glacier Research Model portfolios are subject to annual review Moderate Aggressive (75% Max Equity and 25% Max Offshore) Benchmark: SA Multi-Asset High Equity category Figure 4: Glacier Research Moderate Aggressive Model Portfolio Source: Glacier Research & Morningstar Page 4

5 To demonstrate the retrospective effect of a decision to de-risk the Moderate Aggressive Model portfolio, or switch completely to cash, quantitative analysis of three investment scenarios will be analysed. Scenario 1 No changes to the portfolio Scenario 2 De-risk the portfolio to include 40% cash (STeFI Composite) and maintain the other six funds equally weighted at 10% each. Scenario 3 Totally disinvest from the portfolio and switch to cash (STeFI Composite). 01 December 2016 Decision to: 1) Leave portfolio, 2) De-risk portfolio, 3) Switch totally to cash Figure 5: Investment Growth Source: Morningstar Figure 6: Performance Source: Morningstar Page 5

6 Discussing the results From the investment growth graph in figure 5 above it is clear to see an immediate difference within the first month of the supposed decision to make amendments to the original moderate aggressive portfolio. The de-risked portfolio and total cash portfolio begin to drift toward the category average, whereas the original portfolio continues on a stronger upward trend. When analysing the performance after the switch, it is apparent that by de-risking or disinvesting from the portfolio the investor would lose out on the outperformance of the original portfolio relative to the benchmark. And then also would have begun to suffer negative excess return. This is important as the benchmark used is appropriate for a portfolio built to target a specific investment objective over the long term. By underperforming the benchmark due to cash-trapped investing the investor will struggle to achieve the desired investment objective. Implications of de-risking and disinvesting to cash There are implications that one needs to consider when making the decision to de-risk an investment portfolio or switch completely to cash. The first is, capital gains tax may be triggered and become payable by selling out of the original portfolio. The second, very important factor, is the loss of the compounding effect over time of the potential excess returns that may have been achieved had the portfolio been left to work as originally intended. Conclusion If you are saving and investing for a specific purpose, especially with a relatively long investment time horizon, and need to achieve your goal using high growth assets, then it is highly recommended that you avoid the cash-trap when short-term market volatility hits. Staying invested according to your investment strategy and trusting the investment professionals at the helm of managing your assets can be crucial to your investment success. Having a knee-jerk reaction to short-term pain can seriously harm your investment returns in the long run and also cause you to incur unintended tax liabilities before the time. It is important to remember, that if your investment objective has not fundamentally changed for the future, then you should not significantly tamper with the investment portfolio, especially if it was constructed with the advice of an accredited financial intermediary or investment professional. Page 6