Adding clubs to your investment bag

Imagine for a moment that Ernie Els arrives at next year's SA Open with only one golf club. It won't matter how good the Big Easy is, there is just no way he will be able to win such a big tournament with only one club. Every stroke requires a different club, therefore he will need a set of clubs in order to have a fighting chance of winning the tournament.

Investments operate on much the same principle. Because shares as an asset class have delivered the highest returns over the years, I sometimes find it challenging to convince an investor that they also have to look at other asset classes such as bonds, the money market or property as investment options.

When we take a look at the risk-versus-returns aspect of such an investment, however, we will see that although shares may have delivered greater returns, it also came at a much higher investment risk. Taking control of your investment portfolio starts with determining your personal risk profile. Even though the long-term returns on shares have outperformed the returns on other asset classes, few investors can really afford to invest all of their money in shares alone.

It is often the most vulnerable investors, such as pensioners, who require an income and stability from their capital, who are seldom able to invest in shares, but then also find themselves in financial trouble because of the fact that money market investment returns have a hard time keeping up with inflation after taxes. Many investors then turn to income funds as an alternative in order to earn an extra percentage point or two on their investments.

Income funds are usually recommended for investors with a primary need to protect their capital and a secondary need for income generation. To protect investors against capital erosion, these funds mainly focus on the more conservative asset classes such as the money market, bonds, property and high-dividend shares.

The money market and bonds ensure capital preservation, which is supplemented by conservative interest and coupon payment. Property shares and high-dividend shares offer a riskier addition to a conservative income fund, which in turn offers less security in capital preservation but aims to deliver higher long-term capital growth.

The optimal mix of these four asset classes will be determined by the nature of the fund and the fund manager’s strategy, and although capital growth is much more limited compared to shares and balanced funds, this type of investment can still be a valuable addition to any investor’s portfolio.

When we take a look at the list of available South African income funds (unit trusts), we will see that their historical earnings weren’t much higher than money- market returns over the past 10 years (up to October 2016), as income funds only outperformed the money market by an average of 0.79% per year over this period. Even by focusing on the past three years alone, the approximately 1% higher return that income funds have delivered compared to the money market barely seems worth the effort.

What investors often forget, however, are the costs involved in investments. The current average total expense ratio (TER) on income funds amounts to 1.14% per year. At an average rate of 8.94% on the SA All Bond Index, investors can expect to earn around 8%, which isn’t that much higher than current money-market rates.

But investors can invest in these asset classes in their personal capacity, and save a considerable amount in costs in the process. The fact that bonds trade in blocks of R1m doesn’t mean that investors cannot purchase smaller units. I’ve seen investors invest as little as R50?000 in government bonds.

What makes these investments so interesting is firstly the fact that it is relatively cheap when compared to shares (at an average of R800 per transaction per R1m block of RSA government bonds, with a minimum of R500 per transaction), and secondly it is extremely simple. If you would like to purchase R100 000 in government bonds, it will cost you R500 in purchasing costs (or 0.5% of your capital). Of course this doesn’t make bonds a better investment than shares, but as I mentioned in my Ernie Els analogy, different clubs are required for different shots. These funds are to the disposal of every investor – be sure to include them to get the best out of your investment portfolio.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 27 October edition of finweek. Buy and download the magazine here.