Reichtec May 2017 Newsletter

Cash

When you look at your investment report you will notice that one of the asset classes shown is “Cash” (both local and global). This may seem counter-intuitive as cash over the long-term is unlikely to outperform inflation. Cash however does play an important role in any portfolio.

In this context, cash is not simply money sitting somewhere in a bank account, but is a wider definition which includes all short-term interest bearing instruments where the capital value is not impacted by changes in the prevailing interest rates.

Longer term “interest bearing” instruments are typically bonds. Here the capital value can actually drop if interest rates rise (and vice versa).

While interest rates on bonds may be higher than on cash (short term loans), it certainly makes sense to hold cash (or shorter duration bonds) during periods where interest rates are rising. Essentially this allows the managers of the funds to reset the interest rate at the new higher rate as opposed to bonds where you would be “locked in” at the lower interest rate.

Cash also plays an important role even within an Equity fund. If a manager does not have cash available they might miss out on a good buying opportunity or alternatively be forced to sell shares when there are withdrawals from a fund.

Finally, there will be periods where cash is in fact the best performing asset class – typically when markets correct. The real value of cash though at this point is only realized if the cash is used to purchase growth assets when they are cheapest.

Currency

As I have highlighted before, one of the main reasons for the below-average performance of many portfolios over the past year or so has been the strength of the Rand. This has weighed heavily on the performance of both offshore investments (in Rand terms) and the local market where a significant portion of earnings is earned offshore.

Despite the current political turmoil and the recent ratings downgrade, the Rand has remained resilient and is currently trading below R13/$. This is largely because Emerging Markets are receiving greater investment flows as “real” yields are significantly higher than in Developed countries.

As an example, in SA the 10 year bond has a yield of about 8,5% whereas the latest CPI inflation was about 5,5% (giving a real yield of about 3%). In America, yields are currently 2,25% which is roughly in line with inflation at the moment.

This “search for yield” is driving investors to take the additional risk and invest in emerging markets. This is however not sustainable and these flows can reverse very quickly. If South Africa’s local currency debt is downgraded to “junk” status then there will be significant forced outflows as many funds are only allowed to invest in “investment grade” bonds. Current poor growth and the political uncertainty has increased the risk of a further downgrade.

Managing Risk

Risk has been a common theme in the monthly newsletters. Risk takes on many forms in investments, from the market risk of the volatility of returns to the deep risk that inflation poses to the real value of your investment.

Many people are only focused on the outcome, or the returns achieved without understanding the risk taken to achieve a certain result. This is often  hat happens when investors look at the short-term performance of a fund and select fund managers on this basis.

The problem with this approach is that it ignores the amount of risk that was taken to achieve the result. The world however is full of unknowns and a skilled manager will consider many different scenarios – what if things turn out differently (just think of all the surprises last year – Brexit/Trump etc).

A well-constructed portfolio manages risk by diversifying and investing in different assets as well as in different managers who bring a different approach. In an ideal world, you would want all these different assets to perform differently at different times, but unfortunately from time to time there will actually be some correlation. Therefore, even a well-diversified  portfolio will still have periods of good performance and bad performance.

Everyone wants an investment which will give aboveaverage returns without any risk of losing money but the simple reality is that this product simply does not exist.

It can be very tempting to move to “safe” assets (such as cash) during times of uncertainty. Unfortunately, this strategy leads to emotional decisions such as selling when prices have already dropped and then buying again only once prices have risen.

Looking forward, the next 6 months certainly bring a lot of uncertainty with the ANC Elective Conference at the end of the year which is causing an ever-shifting political landscape.

Internationally the UK has elections on 8 June and the results are no longer clear-cut especially after the recent terror attack in Manchester. In America, Donald Trump is facing his own set of problems as he is discovering just how hard it is to deliver on political promises and at the same time faces growing questions about Russian influence in his election as President.

Remember though that there have always been uncertainties, scandals and crises and yet despite all these, over time investment portfolios have never
failed to deliver inflation beating returns. The key is patience and sticking to a sound strategy.

 

Posted by reich_admin

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