‘Myths you shouldn’t believe’

South African investors have too much invested in local markets and may be wrong in avoiding low-interest cash investments, Allan Gray’s chief investment officer says.

Ian Liddle says this is because investors are making investment calls based on three popular beliefs that are in fact myths.

The first myth is that the local economy is healthy.

Liddle says South Africa’s gross domestic product (GDP) has grown by three percent a year over the past decade, and it has been supported by two pillars: rising commodity prices and foreign investment. If either of these supports is pulled, it will have a dramatic effect on the local economy, he says.

Over the past decade, economic growth has been very strong in sectors that benefit from consumer spending.

Consumer spending has been supported by above-inflation increases in salaries and wages, growth in public sector jobs, social welfare grants and increased borrowing, Liddle says.

The strong growth in consumption spending has translated into strong growth in imports, because many of the goods that consumers want have to be imported. Imports have grown at 18 percent a year over the past decade, Liddle says.

At the same time, exports have grown at 16 percent a year, he says, but a closer look at the volumes of exports shows that, rather than an increase in production, an increase in commodity prices has driven the growth in exports, he says.

This means higher commodity prices are funding the rising consumer spending that is supporting the economy, Liddle says.

It is tempting to assume that commodity prices will continue to rise into the future, but that would be counter to history, because the long-term trend in commodity prices – since 1800 – shows that commodity prices are falling, he says.

This is a result of human ingenuity – we have found faster, better ways to produce and consume commodities, Liddle says.

Some people argue that the 200-year trend has been reversed and that commodity prices will continue to rise, he says, but you need to be brave to bet against human ingenuity.

Liddle says Chinese commodity consumption is driving resources prices: China is consuming 40 to 50 percent of the world’s commodities, with just over 50 percent of the Chinese economy engaged in building fixed capital. Liddle says he is not aware of any other country achieving this level of consumption in modern history, and it is unlikely that it will be sustained.

The second pillar supporting the local economy is the inflow of foreign funds, which pays for the current account deficit (the difference between exports and imports), Liddle says.

Since 1994, foreigners have been investing about R1 billion a month into South Africa, largely into the stock and bond markets.

On two occasions – in 2003 and in 2009 – these foreign inflows have dried up or reversed, resulting in a strong depreciation in the rand, Liddle says.

The supply of electricity is also a problem that acts as a cap on growth in GDP, he says.

Unless South Africa can find a way to grow its economy without electricity, the economy is unlikely to grow at more than three percent a year, Liddle says.

A second popular belief investors have is that South African investments will continue to perform as they have over the past 10 years and to out-perform foreign investments, Liddle says.

It has been a strong decade for local investments, he says. An investment in the JSE over the past 10 years would have out- performed an investment that tracked the Morgan Stanley Capital World index (MSCI) by more than 300 percent (see the values of a R100 investment made in May 2002 into local and global indices at the end of April 2012 in the graph; link at the end of this article).

However, if you rewind to the 10 years before the most recent decade, the performance of the different markets is reversed, he says. An investment in the JSE would have returned less than half what you would have earned had you invested in one tracking the MSCI (see the values of a R100 investment made in May 1992 into local and global indices at the end of April 2002 in the graph; link at the end of this article).

The third popular myth investors believe is that you cannot afford the low yields offered on cash investments, Liddle says.

However, he says, it does not matter how low are the interest rates you earn on cash, because there have been times in the past when it has been good to have the liquidity to buy into markets at the right price.

Since 1950, the world has experienced uninterrupted growth of its credit markets, Liddle says.

However, following the credit crisis in 2008, deleveraging, or the unwinding of much of the credit granted, has begun.

Some people argue that this is temporary and that the trend of growing credit will continue, Liddle says. However, others argue that there is now a reversal of the long-term trend in credit growth and that we are in for a long period of deleveraging and pessimism, with banks reluctant to lend and consumers reluctant to borrow.

Liddle says deleveraging is a powerful force that will affect financial markets, and if it is a long-term trend, cash would be one of the safest places to be and allow an investor to buy assets more cheaply in the future.

RETURNS ALSO DEPEND ON YOUR BEHAVIOUR

What you, as an investor, do with your investments matters as much as what your fund manager does.This is the message from asset manager Allan Gray.

At client presentations this week, Rob Dower, chief operating officer of Allan Gray, showed how, over 10 years, investors in the manager’s two larger asset allocation funds, the Balanced Fund and the more conservatively invested Stable Fund, had undermined the value that Allan Gray could create for them by moving into and out of the funds at the wrong times (see graph; link at the end of this article).

The Balanced Fund returned 16.6 percent a year over the 10 years to the end of May, but on average investors in the fund received 14.3 percent, which is 2.3 percentage points lower a year over the period. The Stable Fund returned 12.7 percent a year over the 10 years to the end of May, but investors in the fund earned only 10.5 percent a year, which is 2.2 percentage points lower each year. (The quoted returns are after costs.)

Dower says investors reacted to short-term performance in the fund and tended to be eager to invest in the Stable Fund after it had performed well relative to the FTSE/JSE All Share index (Alsi) and to disinvest when its returns relative to the Alsi were poorer. However, when the Stable Fund’s returns a year later were considered, strong flows into and out of the fund had often been badly timed in respect of the fund’s out- or under-performance of the Alsi.

Dower also made his point by referring to the returns earned by a living annuity investor using Allan Gray’s linked-investment services provider (Lisp) platform. Through this platform, an investor can access 47 funds from Allan Gray and other managers.

The investor first invested in Allan Gray’s Equity, Balanced and Stable funds through the platform in 2006 – when the equity market was near its peak – and he switched between the underlying funds 10 times over the past six years. The investor’s returns would have been 15 percent higher if he had left his money as he had first invested it.

The money the investor lost as a result of switching into and out of funds on the platform cost him more than two years’ of the income he is drawing from the annuity.

Dower says the investor would also have done better if he had invested only in Allan Gray’s Balanced Fund or Stable Fund and had not switched. This is not to say you should never switch funds, Dower says, but rather that you need to be realistic about your ability to add value by switching funds if you want to avoid undermining the returns a manager can earn for you.

Graphs: Values of R100 investment in local and global indices

Graph: Allan Gray Stable Fund flows