Many South Africans, particularly older ones, rely on the interest earned from their investments to fund their daily lives. With relatively shorter investment horizons, investors tend to invest more conservatively for fear of more risky assets like shares falling and reducing their capital base. So, these South Africans prefer interest rates to be as high as possible so they can afford more of life’s necessities and luxuries.
Other South Africans, typically younger ones and, perhaps, business owners have a different view. They might well have bonds on their houses, credit card accounts or overdrafts on their business accounts which also depend on interest rates. These South Africans would far rather have lower interest rates so they can afford their debt.
Unfortunately, these interest rates are inextricably linked to each other so the two groups are constantly wanting the opposite things. Very broadly, banks lend money to the second group at a rate of interest higher than the one they give to the first group and the difference is how banks make profits. The gap between the two stays fairly constant.
The chart below shows the difference over time between the prime borrowing rate – the rate at which banks lend to their preferred customers – and the standard deposit rate in a savings account. Of course, there are always ways of sweetening the latter rate by investing for longer or taking advantage of a senior citizens’ deal, for example.
Prime lending vs Savings
Source: South African Reserve Bank, MitonOptimal
The bottom line is set off the Reserve Bank’s “repo” rate which receives all the news when the Reserve Bank changes the rate. It uses this interest rate to control the demand and supply of money in the economy.
It is clear from the chart above that interest rates have been coming down this year making it increasingly difficult for people living off that interest to afford the basics. So, investors are forced to seek higher-yielding investments. Unfortunately, it’s a fact of investments that higher yield nearly always carries higher risk.
Many investors aim for higher interest rates by investing in a range of unit trusts that specialise in achieving higher interest rates by investing in longer term investments, property, government bonds, corporate bonds, preference shares and sometimes offshore investments instead of just cash investments like a money market or fixed deposit investment. These investment teams are highly specialised and target incrementally higher returns while trying not to expose the investor to risk. They tend to target a return above inflation like CPI+3% and the better ones are successful in doing so.
The challenge for the average investor is picking which ones are the successful ones. Typically, one looks for an investment manager that can beat the target by a little bit so that they can still hit the target if something rare goes wrong.
In March this year, one of those rare events did occur and nearly all the so-called “Flexible Income” funds lost some of their investors’ capital as a couple of events occurred simultaneously. Firstly, and obviously, the effect of the COVID-19 pandemic started to be felt in investment markets. This meant that foreign investors sold out of South African investments at the same time as it became obvious that some businesses would not be able to pay rent to their property landlords. Most of the Flexible Income funds had a small exposure to both South African government bonds and property and investors became nervous when they saw their traditionally safe funds lose a small amount of capital.
The chart below shows the Money Market rate over 5 years (in blue) compared to CPI+3% (in red) and two flexible income managers, one successful (in green) and one less so (in purple).
Flexible income portfolio performance
Source: FE Analytics 20/05/2015 – 20/05/2020
A couple of things are obvious from the chart:
1.The difference between a good Flexible Income manager and a less successful one can be quite wide. The difference shown above is over 2% per annum.
2.The better ones beat both the CPI+3% target and Money Market investments. They also beat them by enough to weather the storm should events like we saw this year occur.
3.The poorer ones don’t even beat the Money Market and certainly can’t cope with any mistakes.
To pick the better ones requires considerable amounts of research into the holdings in the portfolios, meetings with the portfolio managers and analysis of their investment philosophies and processes. It is usually better to combine at least two of them to avoid risking all the investment with one manager.
Companies like Discretionary Fund Managers specialise in this sort of research and can be relied upon to conduct the required research to construct portfolios likely to achieve investors’ targets reliably.
The content of this article is for information purposes only and does not constitute an offer or invitation to any person. The opinions expressed are subject to change and are not to be interpreted as investment advice. You should consult an adviser who will be able to provide appropriate advice that is based on your specific needs and circumstances. The information and opinions contained herein have been compiled or arrived at from sources believed to be reliable and given in good faith, but no representation is made as to their accuracy, completeness or correctness.