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The Gradidge Patch

shift happens…

Why does risk matter when chasing portfolio returns?

I chatted to a new client recently. He had been managing his investment portfolio himself before deciding that it was starting to take up too much time, and that he really did not know how to. After taking him through our investment planning process, we came up with a proposed portfolio for him. Before we could implement the restructure, he asked for an historical analysis where he could compare the proposed portfolio to his existing portfolio.

I sent him the graph below with my analysis:

linechart 381

He was on the phone shortly afterwards. Why should he invest in a portfolio that has underperformed his existing portfolio? Surely it does not make sense to do the restructure? I was expecting some resistance after seeing the analysis. My response to him was simple. The proposed portfolio was designed with his objectives and risk profile in mind. While the existing portfolio had a better historical performance, it had close to double the volatility as the proposed portfolio, and was riskier than his risk profile analysis suggested. He hit back; why does risk matter when I want returns?

This question stopped me in my tracks somewhat. We had had a long discussion about portfolio construction, his risk profile, his objectives, portfolio costs, etc. so I knew that we had discussed this. Did he forget our conversations? Was I not clear enough in the conversation about risk and return? Did I need to revise our investment process?

So, why does risk matter?

Most investors accept that there is a trade-off between risk and return. In order to get a higher return an investor needs to accept higher risk (volatility) in their portfolio. However, many investors, like my new client, did not understand why risk mattered. My first comment to him was that risk was a bit like his appendix; it did not matter until it mattered. According to WebMD some experts believe that the appendix is just a remnant of our evolutionary past. The appendix serves no functional purpose. However, if it ruptures or becomes infected, it can lead to serious pain or even death. Hence the phrase; it doesn’t matter until it matters. Risk is a bit like this.

I reminded the client that one of the reasons he got in touch with me is because he was uneasy at the high volatility in his portfolio over the past three years in particular. He had been invested in the various funds in his portfolio for about 4-5 years. This reason for reaching out to me was the reason that risk matters; portfolios with high levels of risk tend to trigger off destructive investor behaviours. He was about to sell out of his portfolio when a friend (who is a client of mine) suggested he come talk to me. He had already stopped allocating new funds into his portfolio, and was redirecting those funds to a more conservative money market account.

Evidence of investor behaviours can be observed by looking at the unit trust industry statistics that are released on a quarterly basis. Volatile, sector specific funds tend to experience significant outflows AFTER a period of poor performance. Because these are sector specific, high risk funds, losses can be significant within a short period of time. The large outflows are evidence of those poor investor behaviours being triggered. Broad based, multi asset funds tends to experience significantly less dramatic flows.

This client’s existing portfolio was 100% in local equities, while the portfolio I proposed was well diversified. This diversification is what leads to the lower portfolio risk, but not a correspondingly lower return outcome. This leads to the second point; not all risk converts into return. I always try impress on my clients that risk rewards up to a point. Beyond that point it can be destructive. That destruction comes from higher downside experienced by risky portfolios. This was also evident in the client’s portfolio. Between November 2015 and January 2016 the client’s portfolio was down over 15%. From January 2016 to March 2016 the portfolio was up 18%. But From November 2015 to March 2016 the portfolio was up 0.5%. Over the same period the proposed portfolio was up 3.6%. The reason for the outperformance is that in order to recover from a 15% loss the portfolio needed to achieve a return of 17.6% just to make up the loss. Only then could it start delivering positive returns.

The trick is to find that point at which risk becomes destructive. What we do is look at the client’s investment objectives and horizon to get a sense of how much downside risk we can accept in the portfolio. The long term average return from shares on the JSE is around 13% p.a. so if a client is comfortable with a negative return over a 1 year period, then we can accept downside of 10-12%. If the client has a longer investment horizon and is more tolerant of negative returns in his portfolio then we can increase the capacity for downside risk with the aim of a higher return over time. We would not structure portfolios with downside potential of over 25%. Given the time that it would take to recover from such a loss and start making inflation beating, it is possible that the upswing in the market will have run out of steam.

So yes, risk certainly matters when it comes to chasing returns. It matters because it can trigger the wrong investor behaviours, and it matters because too much of it can destroy portfolio return over time.

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Are Balanced Funds broken?

I have been a believer in balanced funds for many years now. The simple balanced fund offers investors good exposure to growth assets, and lower volatility than the market. A well run balanced fund can outperform the equity market over time if the manager is able to get asset allocation right. Numerous balanced funds have long term track records with better than market returns so it possible. The rise of passive balanced funds has added an additional dimension to the market as investors can now access the benefits of balanced funds at a fraction of the cost that most active managers charge.

A few weeks back I sat for an annual portfolio review with a client. He has been a client for three years and like many investors, was concerned about lower than expected returns over the period. After the usual discussion around market conditions, he asked for a bit more analysis. He wanted a comparison of his portfolio relative to the relevant unit trust sector as well as the asset classes. The discussion revolved largely around his preservation fund, so the appropriate sector for comparison was the multi asset – high equity category, the category where most balanced funds sit. Fortunately for us his portfolio had done relatively well compared to the sector, but something in the analysis caught my attention.

From the graph below you see that balanced funds have, on average, underperformed equities, cash, bonds and listed property over the past three years. This surprised me somewhat as balanced funds are able to allocate between sectors, and over most medium to long term periods return lower than the growth assets (equities and property) but above income assets (bonds and cash). There should also be some ‘return’ from manager skill as the manager moves between the asset classes; at least that is what is often offered to investors in the marketing material.

linechart 375

It must be noted that this has not been the experience for the majority of investors in the sector as the ‘big 5’ balanced funds outperformed the average and equities over the period, although not by a worthwhile margin. Sector leaders over the period, Centaur and Bridge, fared significantly better with the former delivering a solid 42% return over the period. That is more than double the sector average. This highlights one shortfall of simply looking at the average. However, given the sheer size of the sector, and that the bulk of investors’ pension monies are invested here, it is not unreasonable to expect that, on average, the sector should outperform at least one of the asset classes. So why would there be this underperformance of all the asset classes over the past three years?

Fees

In a low return environment fees become a significant factor in terms of performance. It is unsurprising that the passive balanced funds with 3 year track records all outperformed the sector average over the past 3 years, after fees. A fund with a 1.5% p.a. fee would have needed to have delivered over 25% over the period before fees in order to underperform cash on an after fee basis. There are numerous funds with TIC’s (total investment charge) of over 2%. I think that fees have been a major contributor to this underperformance at a category average level. Passive balanced funds would have had to return 22% to deliver similar underperformance to cash as their expensive active counterparts.

Asset Allocation

Multi asset funds, including balanced funds, in South Africa had a 5% exposure to listed properties at the end of December 2016. Fund managers have been chronically underweight listed property for many years. This has led to investors losing out on the excess returns provided by the asset class for an extended period of time. Fund managers have consistently called the listed property sector wrong, and have costed investors potentially billions of Rands in returns over the past 15 years. This is one of the reasons passive balanced funds have outperformed as the managers there do not take a view on the asset class. Most passive balanced funds have had between 5% and 10% exposure to listed property. Managers like Bridge that have a strategic high property exposure have done exceptionally well over the past three years.

The other area where asset managers have failed investors has been in getting the asset calls wrong. Many funds underperformed in 2016 as managers continued with the momentum trade of 2012 – 2015, with lots of Rand hedge industrials and maximum offshore exposure. Boutique managers like Bridge, Obsidian and ClucasGray’s Equilibrium fund are examples of active managers that were positioned for a stronger Rand in 2016.

Conclusion

The picture over the longer term does look a lot better as the average balanced fund has managed to outperform cash and bonds, but underperform equities and listed property. However, if the current volatile market conditions persist much longer it could be harder for expensive balanced funds to deliver value to investors. I do not think that balanced funds are broken – yet. I think that investors need to pay more attention to some of the details like fees and asset allocation a bit more. Simply avoiding expensive funds is half the battle won!!

Complaining about Black Tax ain’t going to help anyone…

Black Tax is real. I know because I pay it. The hashtag #blacktax has a way of making an appearance on Twitter reasonably often. It is one of those topics that never seems too far away from the discussion, especially among Black South African millennials and Generation Xers.

However, as much as we South Africans like to think that we are somehow unique or special, the reality is that Black Tax is a global phenomenon known elsewhere as the ‘Sandwich Generation’.

What is Black Tax?

Black Tax (BT) refers to those extra expenses that Black people have primarily as a result of being Black in South Africa today. It specifically refers to the money that we have to spend on our extended families; in the form of a monthly stipend to multiple households, or paying for the education a number of children that are not ours, or having to contribute significant lump sums for a funeral. BT is seen largely as a legacy of apartheid where our parents and grandparents were denied economic access, and as a result have largely become dependent on the current generation for subsistence and dignity.

What is the Sandwich Generation?

The sandwich generation refers to those people that find themselves sandwiched between their kids and their parents in that they have to support both financially. The growth of the sandwich generation is an international phenomenon, with developed countries such as the US and the UK experiencing massive growth in the number of people falling into this group. In the US it is largely the Baby Boomers and Generation X’ers that find themselves part of the sandwich generation, primarily as a result of longevity (their parents are living much longer) coupled with the fact that their children are staying at home longer due to increased unemployment and extended study schedules.

It is estimated that 36 million people in the UK live in multi-generational homes, while over 20 million baby boomers alone are classified as sandwich generation. In Australia more than 20% of households are multi-generational, while close on 23% of working South Africans are classified as sandwich generation. According to a Pew Research Centre study on the sandwich generation in the US, lower income households are more affected than higher income households, while white families experienced a lower incidence of sandwich generation compared to their black and Hispanic counterparts. The South African experience is similar to this according to research conducted by Old Mutual.

What’s the problem then?

BT is not always explicitly asked for, but there is often an implicit expectation especially from those that have ‘made it’. I, and most of the people in my network, find ourselves paying BT, and the issue tends to raise its head after a particularly bad month, where numerous unexpected BT payments have to be made, often causing financial strain. As the financial adviser in the group I am often asked about my thoughts on BT, and how one caters for it from a financial planning perspective. My response is not always appreciated and often generates significant debate. BT is problematic because BT payers often have to find out of budget lump sum amounts at short notice, and often there are numerous such payments needed in any one month. This can be very disruptive from a cash flow and budgeting perspective. These are often emotionally charged situations (funerals, illness, food shortages, etc) so there is often little room for negotiation or options for mitigating these costs.

Naturally a few months of excess BT payments can result in people starting to rebel and voice their displeasure at the unfairness of the situation. Why do we have to pay BT and our white contemporaries not (or so we think)? Why is this happening to me? #blacktax has trended on a number of occasions on Twitter, normally after some celebrity or personality has commented on or complained about BT. Then the pity party starts all over again. And misery loves company.

How to play the Black Tax hand that has been dealt?

I remember a conversation I had with an uncle of mine at a family gathering many years ago. I was still a teenager then. I lost my dad when I was 5 years old, and as many other young boys in my situation, I was bitter about the unfairness of the whole situation. Why me? What did I do to deserve this? I was having another moan and bitch session when my “uneducated” uncle called me aside for a one on one chat. Having heard me moan about the same issue on more than one occasion, he had one message for me. The hand has been dealt – you can either complain about it, or you can play it. One thing is certain though, you cannot undo it, you cannot ask for another hand. You’ve complained about your situation a few times now, but you are big enough to start playing the hand that you’ve been dealt. Complaining is not going to help your situation so you can stop that now. I remember that I did not take his message too heart immediately. In fact I was quite upset that he was not identifying with the unfairness of my situation. I wasn’t ready for the tough love being meted out, but fortunately his message stuck. I could not reverse my situation, so what was my role in the situation?

The same message applies to those of us that pay BT. The hand has been dealt, no amount of complaining will change that. The questions now are; what is our role in this situation? How should we respond to BT and the challenges it presents? How do we ensure that ours is the only generation that pays BT?

A strategic approach to planning for BT

Personally, I have taken the view that my role is to be the bridge between how things were and how things should be. I see my role as ensuring that the previous generation has dignity, subsistence and respect in their golden years, and that the next generation is teed up and readied for wealth creation and success. I have come to terms with the reality that I may not achieve great wealth for myself personally, and while it seems unfair, it is not as unfair as what the previous generation had to endure. They had a different role to play, now it is my turn to play my part. Otherwise BT will remain an issue for generations to come.

What will have the biggest impact on the financial position of a BT payer and their dependents? From our experience in dealing with many clients that find themselves paying BT, the answer has to be the protection of current and future income. In supporting the previous generation, the current generation, and the future generation, there are great demands placed on the incomes of the current generation. If this income stream is stopped for any reason, the effects are quite devastating. Therefore, protecting this income against any unforeseen issues is critical.

Looking forward though, numerous studies have found that the most powerful way to lift a family out of poverty is education. As the old Chinese proverb goes ‘give me a fish and I eat for a day, teach me to fish and I eat for a lifetime’. But education is a long process, and it takes time before the impact of education manifests for a poor family. But when it does it is often meaningful and sustainable.

So from a defensive perspective, protect income. From an offensive perspective, educate as many people in the family as possible. My role is to pay for this and try and hold everything together.

Protecting current and future incomes

We suggest a number of practical financial planning steps for those that find themselves paying BT:

  1. Draw up a family budget: budgeting remains the foundation and cornerstone of good money management, particularly when it comes to managing household income. It is advisable to involve those affected by the family budget and involve them in the process, particularly where one is supporting adult children. Also, include contingency funding in the budget, so that surprise BT payments can be sourced at short notice
  2. Consider tax planning: A qualified planner should be able to help structure finances in order to be tax efficient. A good tax planner is worth the fee where an individual has built up a big estate
  3. Ensure that all risks to income are mitigated: insurance plays a critical role in ensuring that household income continues in the event of death, disability, disease or retrenchment of income earners. A financial plan for a Black Tax payer should start with a thorough risk analysis and proper estate planning to ensure that intergenerational succession happens smoothly, and without unnecessary tax leakage.
  4. Retirement planning is key: if BT is to be a one generation phenomenon, then retirement planning is key to achieving this. A proper plan will ensure that the current generation does not become dependent on the next generation, and that future income is secured.
  5. Understand medical funding options: the cost of medical expenses in South Africa can be significant, especially for elderly people who often require some form of chronic medication or multiple hospital visits. There is often confusion around the issue of hospital insurance versus a hospital plan, and which is more suitable especially when it comes to covering an elderly parent or grandparent.
  6. Work with a Certified Financial Planner: a financial planner can help with appropriate goal-setting, budgeting, drafting and implement a proper and thorough financial plan. A financial product salesman on the other hand is more focused on selling product and has little consideration for the long term or the client’s interest.

Educate the next generation

While it is important to defend what you have i.e. protect the income that is coming, it is important to also prepare for a future where you are no longer around. Education remains the most powerful tool to lift families and communities out of poverty. The second and third round effects of education are more pronounced for a poor family or community, and remains the most robust long term option. Education trends are changing. Where qualifications used to be the key currency in the workplace, it is now skills that are sort after. Creativity is also attracting a premium price in the workplace with many companies looking beyond traditional roles to grow and innovate into the future.

Conclusion

Black tax is real. I know because I pay it. Complaining about it does not help anyone. Understanding what to do about it is arguably more important if we are to ensure that it is a one generation phenomenon. The hand has been dealt, however unfair it may seem, it still needs to be played.

Help! I’m an MTN Zakhele shareholder!!

It is late as I sit to write this blog. I’ve had a busy day, a sick child, drama at work, traffic and my inbox is full of questions from MTN Zakhele (MTNZ) shareholders. I’ve also had two big glasses of wine! I want to sleep but my bloody conscious is having none of it. I left the comfort of a corporate salary early 2008 because I could see investment opportunities passing my friends and family by. These opportunities were largely public BBBEE share offers. They were not well covered in the media back then, and people were getting poor advice around these schemes. This motivated Kagisho (my business partner) and I to start our practice, Gradidge-Mahura Investments, so we could fill this gap, and inspire others to do so as well. This is what woke me up, this and another query from a desperate and confused MTNZ shareholder. MTNZ is down 5.75% today, and down from over R65 a share less than a month ago, causing some serious stress among investors. So here goes.

There are two types of MTNZ shareholders; those who bought when the scheme was launched in 2010, and those who bought after it listed early 2014. I will deal with these separately. All MTNZ shareholders have to make a decision; rollover their holding into MTN Zakhele Futhi (MTNZF), take MTN shares, take cash (the default option if you do not submit the necessary paperwork to undertake one of the other options), or do a combination of the three options. To get MTN shares one needs to hold at least 200 MTNZ shares, and to convert to MTNZF one needs at least 50 MTNZ shares.

The drop in the price of MTNZ is causing all shareholders quite a bit of stress. It is important to state upfront, whatever decision an MTNZ shareholder takes, it will be done at the NAV of MTNZ, and not the share price of MTNZ on the last day of trading. The NAV of MTNZ is closer to R60 than it is to the R53.17 that it is trading on. This is about an 11% discount to NAV which is high for a deal that matures next month. This clearly demonstrates significant concern on the part of MTNZ shareholders.

Those who bought at launch

Investors that bought when MTNZ was launched in 2010 paid R20 a share for their stake. The share is up about 175% since then. Not a bad performance for a 6 year period that saw the MTN share price largely flat over the same period. These investors have been invested for 6 years now and are faced with more decisions than the public that do not own MTNZ shares. Cash, MTN, MTNZF or a combination? Here are some considerations;

  • Take the cash if you will need the cash in the next year or two
  • Take MTN shares if you may need cash in less than 3 years, or if you need dividend income
  • Rollover to MTNZF if you still have a long term horizon for these funds
  • Consider a combination if you have more than 250 MTNZ shares based on your requirements, and if you have no clear need for the funds, or if you have short, medium and long term requirements for those funds

Those who bought in 2014 and 2015

A number of queries I’ve been getting are from people that bought MTNZ after they started trading in 2014. These people largely paid between R90 and R120 per MTNZ share, and their investment is now deeply out of the money (i.e. in a deep loss making position). It is important that these investors remember that share investing requires an investor take a long term horizon, 5 years at the minimum. Therefore, many of these shareholders have been holding these shares for 2 years or less. For these investors, the most sensible option would be to rollover to MTNZF in order to give the investment enough of a chance. Do not expect sympathy from me – I lost a big sum of money in ABIL’s two schemes. Investing means that the investor is taking on risk, and sometimes that risk may materialise causing losses.

Taking MTN shares would be the next best thing as this would at least result in the investor gaining from dividend flow while waiting for the recovery. Taking cash would result in the investor realising what is a paper loss today.

Conclusion

My final advice to investors is consistent with advice I given to people in the past. Do not stress about making the best decision, rather focus on your decision making process and ensure that it is sound. This way you are clear in your mind about what decision you need to take, that works for you, so that you can make the right decision. Do not beat yourself up when another option works out better than the one that you took, especially if the decision you took was the right one for your particular set of circumstances.

MTNZF could be the next Phuthuma Nathi or the next ABIL. I do not know how it will pan out. However, I am comfortable that many of the issues that the company currently faces will be a thing of the past in the next 8 years. I also know that MTN did not perform well but still caused MTNZ shareholders to make a solid return. For this reason I am going to invest some of my hard earned money there.

How can debt speed up wealth creation

“Better to go to bed hungry than to wake up in debt” Unknown

“Debt is the worst poverty” Thomas Fuller

“A lot of people go into debt just to keep up with those who already are” Unknown

Debt needs to hire an image consultant in my opinion. Google the word debt and you get a number of quotes, including those above. Debt is considered a bad thing by many personal finance commentators and amateur financial planners. The view is that debt is bad, and it can bring you ruin. It is a four letter word and is best avoided.

I grew up getting this advice from family, friends and anyone that felt the need to give me advice. Stay away from debt! Neither a lender nor a borrower be! Debt is bad! And so forth. One did not need to look far for anecdotal evidence of the devastation that debt could inflict on a borrower. The statistics are arguably worse today with almost 50% of borrowers close on 3 months behind on debt repayments. The number of people going into debt review has risen sharply over the past few years, as it tends to do when interest rates rise. The global economy is considered to be in something of a debt crisis at the moment. This is more evidence to stay away from debt apparently.

I regret simply taking the advice of well-meaning adults to stay away from debt. The reason is that I ended up waiting too long to buy my first property. I was a bit too cautious in my earlier years as a result of wanting to pay cash for everything. What I needed to have done was think a little deeper about the issue of debt. Why would something considered universally bad continue to exist for decades? Why are banks some of the largest businesses in world if a big part of what they are offering is bad? Could debt have any redeeming features that I should consider? But first, why does debt have such a bad rap?

Why debt is bad

The reason that debt is bad is not because of debt per se, but rather because of how people use debt. A 2009 survey by TNS Research showed that the reason people borrowed money was largely to fund consumption (to buy groceries, clothing, lights and water, furniture, and pay for school fees). The problem with consumption is that you use up whatever it is you borrowed for. At the end of the day you have debt, and nothing to show for that debt. This type of debt is also expensive debt, so you end up paying a lot more than you borrowed. Because of the consumptive nature of the items funded by debt, what starts to happen is that people develop a habit of funding consumption using debt. So people get used to the idea of paying for groceries, petrol, clothing, etc with debt. By the time they wake up to the problem they are often in too deep, and they have nothing to show for that debt except old clothes and an expanding waistline. Habits are a very powerful thing, especially over the long term.

How can debt make you wealthy?

It is easy really, it just requires understanding, patience and discipline. Debt attracts interest at a rate, usually linked to the prime rate. If you borrow money at say 10% but then use it to purchase an asset that grows at 15% then your wealth increases as the difference in returns compounds over time. If there is a problem at some point in the future, simply sell the asset and settle the debt (yes, easier said than done, but certainly can be done).

Consider the case of the Phuthuma Nathi (PN) share scheme. In 2006 PN bought shares in MultiChoice SA (MCSA) at R50 a share. Investors paid R10 a share, and PN borrowed the remaining R40. Over the years PN used the dividends from MCSA to service the debt. By 2014 PN settled the debt in full.

An investment into MCSA would have grown from R50 to around R300 (500%), and the investor would have made around R100 (100%) in dividends (estimate). That is a stunning return in its own right, but nowhere near the returns achieved by PN shareholders. PN shareholders earned more than R53 a share in dividends and the value of their PN shares is currently R130 a share. PN shareholders made a total return of 33% p.a. compared to MCSA shareholders that earned approximately 23% p.a. over the same period. The use of debt resulted in an enhanced return in the order of 10% per annum in this instance. That is massive and an outlier, but certainly shows the potential. R10,000 invested in PN grew to around R183,000 over the past 10 years, while R10,000 in MCSA would have grown to around R70,000 over the same period.

Many property investors can attest to the power of debt in enhancing returns. However, get it wrong, and you can find yourself in trouble. Shareholders in African Bank’s two public deals lost everything as a result of a debt funded investment in a bad asset. It is important that debt is not used to speculate, and there really is no need to speculate. Rather consider a basket of quality high yielding shares if you wish to attempt to replicate the PN case study. I would also say wait until there is a big pull back in the market (over 20% drop) before attempting such a strategy.

How to make use of debt to enhance returns

An important starting point is to build up a good credit record so that the banks will lend you money. Be prepared to fund initial borrowings from income, until you have built up a decent reserve. Start out small, try different approaches, and be disciplined in terms of understanding the risks to your investments. Finally, be patient, much of the wealth creation comes from compounding the extra return, and compounding works effectively over time.

The point of this blog is to show case another side of debt that is not well understood by many, not to promote the use of debt for investing. Until people have a more balanced view of debt, and its potential, debt is likely to continue to be demonised and only be used by the wealthy to enhance their already massive fortunes.

Understanding the impact of fee structures on portfolio returns

I listened to an advertisement from a financial services company recently. The reassuring voice over states “we don’t charge you until we have first made you a return of….” In other words, there are no initial fees on the product. This sounds very attractive, and judging from the sales numbers, investors are buying this hook line and sinker. However, I recently met an investor who bought into the product when it was first launched in 2012/2013. He was decidedly unimpressed with the investment. His portfolio would have returned over 50% since he invested his money, but because of the fee structure, he only got a return of below 40%. He would have been better off paying the initial fee instead.

Many investors are attracted to investments where there are no initial fees. This is because there is this belief that all their money will be earning a return, and because they do not believe that the adviser has done enough to earn a fee. I can sympathise with this belief, too many advisers sell product and do not offer proper advice. In order to offer proper advice to a client the adviser has to collect a lot of information from the client and do a thorough analysis. Any advice will then be based on the findings of that analysis. Clients can pay for that because they can see what work the adviser has done. In the case of a product sale however, there is not much work besides the preparation of some paperwork, and clients are correct in not wanting to pay for that.

Back to the issue of zero initial fees; many investors believe that they will earn a higher return if they pay no fees upfront, and if the adviser earns a higher ongoing fee instead. I attended an adviser function where an established adviser stated that his fee was 0% initial and 1% ongoing, no negotiation. When I challenged him on the suitability of this fee structure for clients, he was adamant that it was the best approach for them as well. He had built up a large asset base with this approach so he felt that clients were also happy with it.

What do the numbers say?

The issue of higher ongoing fees is relevant to advice fees as well as asset management fees. It is the total ongoing fees that matter most in the long run. Consider three scenarios; one with maximum initial fees and standard annual fees, another with a discounted initial and annual fee, and one with no initial fee but the maximum annual fee. Assume that the funds are invested in the same portfolio.

fees-table

Over the 15 year term, it is the portfolio with the maximum initial fee that delivers the best return to clients, despite having the lowest net investment amount. The scenario with the lowest fund value was the one with the highest annual fee, despite there being no initial fee. These results are consistently the same from 7 years and longer. Below 7 years and it is better to opt for no initial fee.

The reason the scenario with the lower annual fee outperforms is because of the effect of compounding higher returns net of fees. So even though it starts off with the lower initial investment, it is compounding at a higher rate. Over time that compounding effect becomes the greatest contributor to portfolio value. The high initial fee represents a once off transaction; the compounding effect has the greatest impact over time. This makes the fee structure critical for long term investments such as living annuities and retirement annuities.

What fees do clients incur in an investment portfolio?

There are three distinct fees that a client pays when investing via an adviser; Advice fees, Administration fees, and Asset Management fees.

Advice fees: these are paid to the financial adviser. There may be an upfront fee as well as an annual fee. This fee should be to cover the cost of the advice process, portfolio structuring, ongoing monitoring and servicing.

Administration fees: these are sometimes referred to as product fees. Typically they are for fund aggregation, pricing, statements, tax certificates, reporting, and online access functionality. Most of the time there is only an annual administration fee, no initial fee.

Asset Management fees: these are also usually annual fees and cover the cost of asset allocation, stock analysis, stock selection, portfolio optimisation, risk management, compliance and reporting. There are also ancillary fees such as trading costs, auditing fees, bank charges, etc that have to be covered. Some managers have a performance based fee, while many opt for a flat fee. The total fee is reflected in the total expense ratio (TER).

In order for an investor to be successful over the long term it is important that they understand what fees they are paying, and what they should be receiving for those fees. Some companies offer all three components, advice, administration and asset management. As a result they are able to shift fees around, and give the impression that they are cheap. As an investor it is entirely appropriate that you interrogate those fee structures, and ask for clarity on expected total fees.

How do we mitigate fees for clients?

We do a number of things when it comes to fees and our client portfolios. From an advice perspective we charge an initial fee and look to moderate annual fees. In many instances clients have insisted on not paying an initial despite our best efforts to convince them that it is in their best interest over time. We then charge the higher ongoing. What we then look to do is reduce administration and asset management fees as far as possible.

With regards to administration fees, we chose the cheapest product provider. The investment amount can impact on the choice of product provider as some providers have a sliding scale that makes them cheaper for larger amounts. Our clients pay around 0.25% per annum for this.

The area where we can have the most impact is around asset management fees. Here we do a number of things; we blend passively managed funds into portfolios, we favour funds with low and flat fee structures, and we cap exposure to funds that charge performance based fees. We find that asset management fees tend to be between 0.60% and 0.80% per annum, which are highly competitive for retail investments.

It is important that clients understand what they pay, and what they should be getting for their money. If they are uncertain about any aspect then they should be persistent in seeking clarity, especially for long term investments where high fees can lead to low returns, and a poor investment outcome.

MTN Zakhele Futhi: yay or nay?

The long awaited announcement of the new MTN BBBEE deal happened on 22 August. MTN and MTN Zakhele (MTNZ) both announced that MTN Zakhele Futhi (MTNZF) would replace MTNZ deal post the unwinding of MTNZ in November 2016. The black public is invited to apply for shares in MTNZF while MTNZ shareholders have an option to convert all or a portion of the MTNZ shares to MTNZF shares.

Administration issues

The prospectus became available on 12 September 2016, and investors have until 21 October 2016 to submit their application forms and deposit their funds. Investors can either download the prospectus from www.mtn.com/zakhelefuthi or pick one up at a participating Nedbank branch. Investors can also complete the application form online or contact 083 900 6863 if they need any assistance with the application process. It is important to note that investors must not sign the application form until they are requested to do so in a Nedbank branch. Nedbank will request FICA documents (copy of ID, proof of address, and proof of banking). Funds need to be paid across by 18 October 2016, while cash deposits (maximum amount of R24,999) need to be made by 21 October 2016.

Deal structure

The empowerment period is 8 years, with no trade possible in the first 3 years. Restricted trade between qualifying black investors will be possible in the last 5 years. The deal will not happen if less than R1.24bn is raised between the black public and MTNZ shareholders opting for the Re-investment offer.

The MTNZF deal is similar to the MTNZ deal in many ways especially with regard to transaction funding. The funding structure is summarised below:

Source of funding R’millions Weighting Per MTN share
Equity (from public and MTNZ Re-investment) 2,468.3 25.00% R32.12
Upfront costs and working capital (R39.4) (0.4%) (R0.51)
MTN discount (20%) 1,974.7 20.00% R25.70
MTNZF Preference Shares 2,418.5 24.50% R31.48
Notional Vendor Financing (NVF) from MTN 3,051.2 30.90% R39.71
Total 9,873.2 100.00% R128.50

Given the similarities between MTNZF and MTNZ in capital structure, perhaps there will be similarities in the returns achieved by both deals. MTNZ has delivered a return of over 200% since inception in 2010. The one key difference between the funding structure of MTNZF and MTNZ is that there is refinancing risk presented by the preference share funding. The preference share funding is for a period of 5 years, after which it will be either renegotiated with the incumbent preference shareholders, or with new funders. It presents both a risk and an opportunity, if the debt is refinanced on more attractive terms. This is not a deal breaker as the preference share funding comprises 24.5% of the deal. The debt covenants do not appear unreasonable, although a 25% drop in the MTN share price could pose a significant challenge in this regard.

MTNZF directors will have discretion from year 4 onwards to pay a dividend equal to a maximum of 20% of the dividend income they receive from the MTN shares in MTNZF. This is an improvement on the MTNZ deal which did not allow for dividends during the entire empowerment period. Many MTNZ shareholders complained about the lack of dividends from MTNZ.

MTN: The investment case

MTN finds itself in a tough place at the moment. For the six months ending 30 June 2016 it reported a headline loss per share of 271 cents, which was down from earnings of 654 cents in H1 2015. While the Nigerian fine was a significant factor, there were other issues surrounding joint ventures and touch economic conditions in key markets. The company experienced a 48 hour network outage in SA in February 2016. Major risks include increased competition in key markets, political risk in Nigeria in particular, the economic outlook for Nigeria given low oil prices, and reducing voice revenues.

On the positive side the company still has the largest footprint in Africa, which could make it a takeover target for one of the larger global networks. There is strong growth in wireless data and broadband, and capital expenditure is expected to slow going forward.

There is a new management team that will be taking up the challenge of driving the company forward. The market seems to be optimistic that they will deliver the needed turnaround strategy.

Conclusion

Investors have essentially been given a second bite at the proverbial cherry with this deal. MTNZ was a success despite the fact that the MTN share price is largely where it was when the MTNZ deal happened. This is testimony to the funding structure which proved resilient in the face of challenges. The MTNZF deal has a very similar structure.

Investing is about taking risk, and the risk that investors could lose their entire investment remains. It is a risk that I am willing to take for myself, my wife and my kids, but I will not be betting the farm on this one.

What it truly means to take a long term perspective

In 1974, sociologist Dr. Edward Banfield of Harvard University wrote a book entitled, “The Unheavenly City.” He described one of the most profound studies on success and priority setting ever conducted. Banfield’s goal was to find out how and why some people became financially independent during the course of their working lifetimes.

He finally concluded that the major reason for success in life was a particular attitude of mind. Banfield called this attitude “long time perspective.”  Time perspective referred to how far you projected into the future when you decided what you were going to do or not do in the present.

One example given in the book was the decision facing many school leavers – get a job or study further? Having a short time perspective would point to getting a job because you start ‘making money’ sooner than studying. However, research has shown that over the duration of a career, the average skilled or qualified person can earn more than double that of the average unskilled worker, despite starting to earn an income a few years later.

This attitude of a long time perspective is often found in successful entrepreneurs and executive managers in large corporations. This ability to take a long time perspective sometimes leads to decision-making that does not make sense for outside observers, who often have a short time perspective when judging such decisions. I sit in wonder when I listen to people complaining about the traffic jams being caused by the road works on the M1 South. “We’ve got to deal with this traffic for another 2 years!” is the usual refrain. Having driven that road for the past 20 years, 2 years seems insignificant. Over the long-term it is a good thing, over the short-term I’ve adjusted my routing and I actively avoid the M1 South.

A long time perspective for investors needing income

I read an article where a number of financial advisers were asked for their opinions on where investors could invest for income. A ‘highly rated’ adviser suggested a product with an investment term of less than 3 years because it was currently offering a high yield. My immediate thought was “what happens when the product matures in less than 3 years time?” My faith in my profession was restored when another lesser known adviser recommended a combination of asset classes including a chunk in equities.

Consider for a moment two retirees who were facing the decision of where to invest their R1m pension on 1 January 1999. Income funds are yielding over 13% and equities are yielding about 5% at the time. Pensioner A has a short time perspective and chooses the Income fund yielding 13%. Pensioner B has a long time perspective and invests in the equity fund yielding 5%. Pensioner A earns a higher rate of income until 2003 when income growth (and a bit of luck) kicks in for Pensioner B. B then earns more than A from then on, earning as much as 3x more income in some years than A. Cumulatively, A earns more than B until 2006 as a result of the large gap in the beginning. However, come end December 2010 – A has earned approximately R1.7m income and his capital is worth R1.07m. Pensioner B on the other hand has earned over R3.6m income and his capital is worth north of R8m.

linechart 349

(It is never wise for any investor to only invest in one fund or one asset class – the best solution for most pensioners would probably be a combination of both funds, and other funds such as property and offshore).

The difference between income funds and equity funds is that the yields from income funds are based on largely on the interest rate cycle. The yield from equities comes from dividends paid by companies. The thing with the interest rate cycle is that it varies around an average over time. Interest rates go up, then they come down, then they go up again. Dividends on the other hand start at a point and grow from there. The growth rate in dividends varies over time, and can be negative at times, but generally maintains pace with inflation. At some point the effect of compounding kicks in – and the income from equities outstrips that of fixed interest alternatives. Property income also shares this trait with equities – growth compounding over time leading to a higher income over time.

Why are more investors invested in cash and bonds then?

One possible reason is that equities and property are volatile over the short-term from a capital perspective. This deters a lot of investors, and retirees / pensioners in particular are put off by volatility. It is a very uncomfortable thing seeing one’s investment down by double-digit percentages, and then still drawing income from such investments. See the capital performance of the two funds referred to in the graph above. There are numerous periods where the capital value falls more than 20%. Many income investors are unnerved by this. They still equate the capital value of an asset to wealth, and ignore the ability of the asset to generate income over the long-term.

linechart 350

Another reason income investors favour bonds and cash over property and equities is that many retire without having saved enough for retirement, and are then forced into a short term mentality where they have to invest where the highest yields currently are. A third possible reason, as mentioned earlier, even ‘reputable’ market commentators are sometimes prone to a short term mentality.

A long time perspective and investing for growth

Financial and investment articles published in December and January in particular often contribute to short-termism by growth investors. This year they may have read articles like “where to invest in 2016” or “the A – Z of investing in 2016” or “stock picks for 2016”. Investors’ language often betray this short-term perspective. I often get asked “where is the best place to put my money at the moment” or “what’s doing well now”? Investor behaviour also tends to show up this short-term thinking – consider unit trust sales data which show the highest inflows to equities, property, and offshore assets after the respective markets have delivered strong returns.

While these assets are volatile in the short-term, this volatility fades in the long-term, with long term equity returns around the 13 – 15% p.a. level over time. A major threat to an investor’s wealth is inflation. Inflation is a long-term phenomenon which does not impact investors meaningfully over the short-term. By the time it does become an issue for investors, it is often too late for them to do anything about it. Equities and property have both outperformed inflation significantly over the long-term, with cash and bonds marginally outperforming over time, and often under performing over the short term. Once tax has been factored in, cash and bonds struggle to beat inflation.

Conclusion

Taking a truly long-term perspective is about understanding what the best course of action to take now that will lead to the best outcome over time. It is not simply investing in something for a long period of time and hoping for the best. It is an attitude that needs to be developed in all spheres of life, which would make it easier to apply to investment decisions.

The original version of this article appeared on Moneyweb (www.moneyweb.co.za) on 27 February 2012 and was written by myself. This version has been edited and updated.

MTN Zakhele Futhi: too soon to judge!

The long awaited announcement of the new MTN BBBEE deal happened this past Monday 22 August. MTN and MTN Zakhele (MTNZ) both announced that MTN Zakhele Futhi (MTNZF) would replace MTNZ deal post the unwinding of MTNZ in November 2016. The black public is invited to apply for shares in MTNZF and MTNZ shareholders have an option to convert all or a portion of the MTNZ shares to MTNZF shares.

There seemed to be a lot of excitement in the market following the announcement, which is surprising as the prospectus will only be available early September. I have read articles complaining about the 8 year term attached to MTNZF, while others have complained about the 20% discount, and others have complained about both. I do not believe that there is sufficient information available at this stage to make a judgement call on the deal before the prospectus is released.

However, there is some useful information available from the announcement and this is what we know at this stage;

  • The offer will open on or around 12 September and will close on or around 21 October
  • The empowerment period is 8 years, with no trade possible in the first 3 years. Restricted trade between qualifying black investors will be possible in the last 5 years
  • The deal is being structured similarly to the MTNZ deal in terms of funding (discussed in more detail below)
  • The deal will not happen if less than R1.24bn is raised between the black public and MTNZ shareholders opting for the Re-investment offer

The MTNZF deal is similar to the MTNZ deal in many ways especially with regard to transaction funding. The funding structure is summarised below and compared to the MTNZ deal in 2010:

Source of funding R’millions Weighting MTNZ weighting
Equity (from public and MTNZ Re-investment) 2,468.3 24.90% 19.5%
MTN discount (20%) 1,974.7 19.92% 15.6%
MTNZF Preference Shares 2,418.5 24.40% 26.1%
Notional Vendor Financing (NVF) from MTN 3,051.2 30.78% 38.8%
Total 9,912.7 100.00% 100.00%

 

The key difference between the deals is that MTNZF has an 8 year maturity compared to MTNZ at 6 years. I do not believe that the extra two years is significant, in fact it could add meaningfully to MTNZF shareholders as it could result in more debt being settled and a higher conversion ratio of MTNZF to MTN shares at the end of the period. Imagine if MTNZ had another 2 years to go, it is possible that all of the debt in MTNZ would have been settled and investors would have ended very close to a 1:1 conversion of MTNZ to MTN if the dividends from MTN remained largely the same as the past two years.

It will be interesting to see how MTNZF deals with the issue of dividend payments to MTNZF shareholders during the 8 years. My hope is that the prospectus gives directors some discretion on this important issue. Many MTNZ shareholders complained about the lack of dividends from MTNZ.

Given the similarities between MTNZF and MTNZ in capital structure, perhaps there will be similarities in the returns achieved by both deals. We need to wait and see the details around the cost of the debt, the debt covenants, etc. but I expect that they will be largely similar to those of MTNZ, in which case MTNZF could possibly end up being more lucrative for investors patient enough to participate in the deal until maturity.

MTN is arguably in a tougher spot today than it was in 2010 when the MTNZ deal came to market. This may in fact work in MTNZF shareholders favour as they are buying in with the prospect of a recovery in the coming years. MTNZF is buying MTN shares at R102 versus the R107 MTNZ paid, but they are also putting up more equity this time, but MTN is offering a bigger discount this time too. All in all it is pointless comparing the relative prospects; MTNZF looks a compelling offer at this stage.

Important: MTNZ shareholders have to make a decision regarding the Re-investment Offer by 19 October. They can either default to a cash payment, choose to receive MTNZF shares to the value of the MTNZ shares (a minimum of 50 MTNZ shares needed for this option), or opt for ordinary MTN shares (a minimum of 200 MTNZ shares needed for this option). If they have enough shares they could opt for a combination of the above options. MTNZ shareholders that do not make an option will receive the default option of a cash payment provided that their bank details are up to date.

I hope my kids will like their Christmas present this year. They will both be getting MTNZF shares. My daughter will be a teenager when the scheme matures so at least we both have something to look forward too now!

(A shortened version of this article is expected to appear in the City Press on Sunday 28 August 2016)

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