Investing in challenging times

Cape Town - In early March the Dow Jones Industrial Average hit 21 000 for the first time in its history. The rise in the index from the 20 000 level to this point was also the fastest 1 000 point gain ever seen.

Superficially, this and other market highs around the world point to a rally that should have investors excited. They are seeing the value of their investments constantly reaching new levels.

However, there is a growing sense of caution amongst many market analysts. A recent survey by Bank of America Merrill Lynch found that 34% of fund managers believe that stocks are overvalued, which is the highest reading in this study since the Dotcom bubble in 2001.

The price-to-earnings ratio of the S&P 500 is sitting at over 21 times, compared to an average over the last ten years of 16.5. The cyclically adjusted price-to-earnings (CAPE) ratio is higher than it has ever been, apart from in 1929 before the Great Depression and in 2000 before the crash.

The big, developed stock markets have now gone more than eight years without a major drop of 20% or more. During this time the S&P 500 has more than tripled. This is an unusually long period of uninterrupted growth and is good reason for investors to ask whether a correction isn't overdue.

On top of this, political and economic uncertainty around the world is high. Analysts are increasingly wary of whether US President Donald Trump will be able to execute on policies deemed positive for markets, while still worrying about potential policy amendments that could turn out to be negative.

Across the Atlantic, the future of the European Union remains a concern, while local political risk has once again peaked with the cabinet re-shuffle that saw the removal of both the finance minister and his deputy. This will remain high as tension within the ruling party escalates.

Investor response

For investors, there is clearly a high level of risk in equities at the moment. A market pull-back may not necessarily happen in the next few weeks or months, but it is growing increasingly likely.

How then should investors approach equities? They know that they should stay invested over the long term, but that is difficult to do when uncertainty is so high.

A potential solution is to use structured products. These are alternative investments that offer a pre-defined pay-off profile so that investors have some comfort of knowing beforehand what they can expect.

Usually they will offer a return linked to how equity markets perform. However, they add in a capital guarantee so that investors can be sure that they won't lose any of their initial capital.

“If you look at history, the assets that have had the highest return are listed shares on main stock exchanges because those are the best companies in society,” says Investec's Japie Lubbe.

“That is followed by commodities, then bonds, then cash. That is the hierarchy of return. But the hierarchy of risk is exactly the opposite, which means that normally you have to put a lot of money at risk to make money. But with a structured product you can access equity market returns, but take the risk of cash.”

An example is Investec's East Asian Growth Basket (EAGB) that is currently open for investment. It has exposure to a wide range of world equity markets through a basket that combines the Nikkei in Japan, the S&P 500 in the US, Eurostoxx 50 in Europe, and the MSCI Emerging Markets Index.

The minimum investment is $12 000, and the product runs for five years. At the end of that term, investors are guaranteed to receive back a minimum of their initial capital plus 5% if markets are flat or negative over that period.

However, if the basket grows over the five years, investors will receive double the return, from 105 to 127.5, up to a maximum of 50% of their capital investment. If the markets are up 25%, for example, investors will see a 45% return, while if they are up 30%, the return is capped at 50%.

This type of return profile can give investors a great deal of comfort in the current climate, by creating some certainty in very uncertain times. For many, these kinds of structured products can therefore be a very useful addition to an investment portfolio.