Investing too safely might cost you

2012-06-23 10:43

Structured funds that guarantee investors’ capital tend to be very popular after a market crash.

Typically investors that get caught up in the market hype have full exposure to the equity markets and therefore suffer heavy losses when the markets fall.

Investors then tend to flee to funds that guarantee what little capital they have left. However, guarantees always come at a cost as they limit the upside of your investment return by paying out a smaller percentage of the total. In most cases you forfeit dividends from the underlying shares.

After a major market correction, markets tend to recover strongly and investors in guaranteed products lose out on the recovery.

Guaranteed products are also not the correct vehicle for long-term investing. If you have a time horizon of more than five years the likelihood is that the markets will deliver a positive return, yet you have forfeited some of that return, usually in the form of dividends.

For example if you have a share with a dividend yield of 3%, over a five year period that would equate to a 16% return – so effectively the product has cost you 16%, which is very expensive.

However, there is a time and place for guaranteed funds as long as you understand the product, its costs and what you aim to achieve from the investment.

We are currently in a situation where South African equities are relatively expensive and fund managers recommend that we invest offshore.

However, globally the world is in a state of flux as Europe struggles to deal with excessive debt and the entire eurozone threatens to collapse.

An investor wanting offshore exposure with no risk would have to invest in cash, which provides returns of less than one percent.

Investors therefore need to take some risk on investing in equities to see any reasonable growth.

It is with this in mind that Investec launched its S&P500 Growth ESP which is a structured product that guarantees your capital in rands while providing offshore exposure.

Investec’s product offers a three-and-a-half-year investment linked to the performance of the S&P500 index. At the end of the period your initial capital is guaranteed in rands, so you get your money back if the market has fallen.

If there is growth you receive your initial capital plus 110% exposure to the increase in the level of the index.

For example, if you invest R100 000 and the index returned 27% over the period, you would receive 29.7% (as you receive an additional 10% on the index return) which is then converted back into rands providing you with R29 700 (assuming the same exchange rate) plus your capital of R100 000 so you would receive a final payment of R129 700.

The downside is that your original capital investment does not benefit from any rand weakness. If the rand has weakened against the dollar your initial capital investment of R100 000 remains the same. It is only the growth on the investment that would benefit from exchange rate movements.

You also sacrifice dividend income which is currently 2.12% for the S&P500.

The product has a fee of 2.25% and a 0.75% annual fee, although these are built into the costs of the product so will not be reflected in your final return.

An investor wanting similar offshore exposure without a guaranteed structure could invest in Deutsche Bank’s MSCI USA index fund which is one of the db x-tracker range of exchange-traded funds listed on the JSE. This has no guarantees but gives you dollar exposure to the US index.

After fees of around 1% the investor would receive net dividends of 1% per annum and all your capital would be exposed to movements in the exchange rate.

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