In the head-to-head battle for your custom, a small number of financial service companies are using the cost of investment as a major marketing tool – mainly as a consequence of the launch and increasing popularity of exchange traded funds (ETFs).
With the success of the ETFs mainly in the retail market, passive investment managers are now turning their eyes to the retirement savings market.
The ETF market has also opened the eyes of South African investors, both individuals and retirement funds, to the advantages of passive investment in the broader sense. The main attraction is that costs can be dramatically reduced by merely replicating pre-selected investment market indices, and there is no need to pick out an active asset manager from the myriad available.
Historically, the South African investment market has been dominated by active investment managers, who seek to out-perform markets by paying an army of analysts and fund managers to manage your savings.
Working in favour of passive managers is the increasingly confusing array of actively managed investment portfolios and the fact that over a 20-year period less than five percent of active managers actually out-perform their asset class benchmarks.
And over a one-year period less than 40 percent of asset managers beat their benchmarks - and much of their under-performance can be attributed to their costs, according to Steven Nathan, the chief executive of passive asset manager 10X Investments.
The new move by passive asset managers into the retirement market is likely for the first time to put significant downward pressure on the high cost of active investment, particularly in the retirement arena.
Bringing the cost factor into the marketing mix of retirement products in particular comes almost seven years after actuary Rob Rusconi chose the rarefied air of the 2004 annual conference of the Actuarial Society of South Africa to blow the whistle on the exceptionally high costs of saving for retirement in South Africa.
The focus on costs has been stimulated by a number of factors:
* Government concern. The National Treasury is worried about costs in the broader financial services industry and particularly in retirement savings, with Finance Minister Pravin Gordhan giving notice in his national Budget in February that he has ordered a major review of the financial services sector, which will include a close look at costs.
* The cost of choice. Wide and confusing investment choice, with almost 1 000 unit trust funds available as well as numerous investment vehicles provided by the life assurance companies. Very few retirement fund members exercise choice when offered but end up paying for the facility, thereby reducing their savings.
* Better policing. The introduction of the Financial Advisory and Intermediary Services (FAIS) Act and its associated Ombud for Financial Services Providers, who can order financial advisers to make up losses suffered by investors as a consequence of bad advice. This means that many advisers have started to advise on the side of caution. There have, as yet, been no determinations by the ombud purely on the issue of costs of a product, but it is something that can be expected.
* Ensuring a pension for life. Insistence from the South African Revenue Service (SARS) and pressure from the Treasury that investment-linked living annuities (illas) must last for the lifetime of the annuitant. Initially, when these products (which transfer all risk, including investment risk, onto the annuitant) became available to pensioners, many were left facing destitution as a result of two main factors:
* Pensioners were initially allowed to draw down any amount up to 20 percent – but now up to 17.5 percent – of the annual value of their savings. Research over the past few years has shown that any amount in excess of five percent is likely to be unsustainable if a pensioner has a lengthy retirement.
* Pensioners were given exceptionally wide investment choice and the ability to switch between funds. The pensioners relied heavily on financial advisers and sales people who did not have the asset management skills, with the consequence that disastrous decisions were made.
As a consequence of the warning to the industry by SARS, industry body the Association for Savings & Investment SA (Asisa) issued a code of conduct to product providers to encourage restraint. This included ensuring that underlying investment portfolios met the prudential investment requirements of regulation 28 of the Pension Funds Act.
The big winner in all this has been the renewed popularity of what are called balanced portfolios or asset allocation funds, where the investment decisions are made by an asset manager and not an unskilled financial adviser or investor.
By the end of December 2010, the domestic asset allocation sector, after money market funds, had the bulk of assets under management in the collective investments (unit trust funds and ETFs) space, with just over R262 billion invested. Altogether there were 323 asset allocation funds with a track record of more than six months at the end of December 2010.
The sector has six sub-sectors: there are 68 flexible funds, 18 high equity prudential funds, 41 medium equity prudential funds, 69 low equity prudential funds, 78 variable equity prudential funds and 49 targeted absolute and real return funds.
The popularity of balanced/asset allocation portfolios is likely to increase for a number of reasons. These include:
* The Asisa requirement that illa portfolios meet the requirements of regulation 28 of the Pension Funds Act; and in the recent revision of regulation 28 the Treasury has insisted that it be applied at investor rather than at fund level. Prudential unit trust sub-sectors provide ready access to investments in which the asset allocation meets the requirements of the regulation.
* The fear of financial advisers that they may be found wanting in playing asset manager when deciding in what asset classes and funds their clients should invest. There is more than sufficient evidence that many financial advisers have undermined the value of their clients’ investments rather than having added value.
* The passive manager crusaders have chosen balanced/asset allocation funds as the new battlefield on costs, aiming mainly at retirement savings.
The current problem with index tracker funds such as ETFs is that individual investors have to do their own portfolio construction to diversify their risk across asset classes. There have been limited opportunities to access index tracker funds through most of the linked investment services provider (Lisp) companies, which provide access mainly to the unit trust funds of a wide range of management companies as well as to retirement fund legal umbrellas, such as retirement annuity and preservation funds.
The reason most Lisp platforms do not provide access to ETFs with their retirement savings, illa and discretionary savings products is that most of them have not upgraded their technology to provide investors with direct access to securities markets.
Momentum Administration Services, Absa Investment Management Services (AIMS), and AOS’s ITransact are among the few Lisps that offer ETFs on their platforms.
It is into this mix that some of the passive managers are now intending to enter the fray by offering their version of balanced funds, namely multi-index tracker portfolios.
The Old Mutual Investment Group SA (Omigsa) passive manager, Dibanisa, which has the capacity, in association with Omigsa, to provide balanced tracker portfolios, is strangely staying out of the fray, even though it does market unit trust index tracker funds and passive portfolios for retirement funds.
Multi-index tracker portfolios come in a number of different forms, with a number of these diverse structures being used by the providers of the first of these portfolios.
The options range from putting together a portfolio of ETFs without the portfolio being an ETF, providing an ETF in which the underlying investments are tracker portfolios but are not necessarily ETFs, and providing portfolios in which the underlying investments may or may not be ETFs but are passively managed investments.
The first entrants into the multi-index tracker market are Absa Capital, etfSA.co.za (in association with Nedbank Capital) and 10X Investments.
Absa Capital
Absa Capital has launched two new ETFs with underlying passively managed portfolios tracking various asset classes. These products are the first of their kind in the South African market. The underlying portfolios are not ETFs.
Vladimir Nedeljkovic, the head of investments at Absa Capital, says the ETFs from Absa Capital’s Multi-Asset Passive Portfolios Solutions (MAPPS) are structured within the requirements of regulation 28 of the Pension Funds Act. The MAPPS Growth ETF is aimed at individuals or retirement funds seeking capital growth, while the MAPPS Protector ETF is aimed at helping people nearing retirement or in retirement to protect their capital.
The MAPPS Growth ETF holds 75 percent of its portfolio in domestic equities (tracking the FTSE/JSE Swix index), 10 percent in nominal government bonds, 10 percent in inflation-linked government bonds and five percent in cash or a cash equivalent.
The MAPPS Protector ETF holds 40 percent in domestic equities, 15 percent in nominal government bonds, 35 percent in inflation-linked government bonds and 10 percent in cash or a cash equivalent.
In all asset classes the funds track various vanilla indices to keep costs as low as possible.
Nedeljkovic says the MAPPS ETFs will “about halve the costs from providers of balanced funds”.
He says that at a later stage several other products in the MAPPS range will be brought to market.
Nedeljkovic says the products should be attractive to individuals as well as to smaller pension funds, which “have not been served well by current service providers. The MAPPS ETFs will be very cost-effective for smaller funds.”
Nedeljkovic says that Absa Capital is not using other ETFs as underlying investments because this adds another layer of costs.
Absa Capital will not directly offer products using legal wrappers such as retirement annuities, but such products will be offered by third parties. He says Absa Capital is an investment product provider and does not do the administration that is required for providing legal wrappers.
etfSA.co.za/Nedbank Capital
The etfSA.co.za product is a range of risk-adjusted balanced portfolios made up of underlying ETFs that are initially being made available to individuals under the legal wrapper of a retirement annuity or a preservation fund.
Nedbank Capital will blend available ETFs into the etfSA.co.za-exclusive portfolios using the retirement fund licence of etfSA.co.za, which provides access to all ETFs through the AOS Lisp administration platform.
Mike Brown, the chief executive of etfSA.co.za, who spearheaded the launch of ETFs in South Africa in 2000 as the then chief executive of Satrix, says that the plan is eventually also to make the portfolios available for illas.
For the retirement annuities (RAs) and preservation funds you will not be able to choose the individual tracker funds yourself, but you will be able to select from a number of portfolios, which will be structured by Nedbank Capital on a risk basis, with targeted above-inflation returns. You will be informed of the underlying components.
The portfolios will meet the investment requirements of regulation 28.
Brown says an all-tracker RA fund has been made possible by the rapid increase in the number of ETFs available. Initially, there were only Satrix funds, which were limited to equity markets. Now there are ETFs that track the other asset classes of property, bonds, commodities and cash.
Brown says the ETF RA fund will enable the transfer of retirement funds or preservation funds from other product providers to its ETF-based retirement portfolios.
The benefits of the etfSA.co.za offerings will be complete transparency, easy switching between funds, competitively low costs and access to all asset classes. The next step will be the introduction of illas in which all the underlying choices will be ETFs, Brown says.
Nerina Visser, the head of Beta Solutions at Nedbank Capital, says three portfolios will be offered through etfSA.co.za: a conservative portfolio designed to provide a return of inflation plus three percent; a moderate-risk portfolio, which will aim at inflation plus five percent; and an aggressive portfolio which will target inflation plus seven percent, all measured over a rolling three-year period. There are no guarantees provided.
She says the portfolios are based on long-term strategic asset allocation into a broad range of asset classes, and are allowed to drift – within pre-defined tolerance limits – around the strategic allocation weights. No active allocation is made at any time.
The allocations have been determined through what is called a quantitative optimisation model, based on 50 years of historical data, covering various market cycles and economic conditions. A quantitative model uses mathematical predictors based on historical facts to determine outcomes without human intervention.
While these specific portfolios have been made exclusive to etfSA.co.za for retail investors, Nedbank Capital will make them available to the wholesale market, namely for retirement funds.
Visser says that there is a significant opportunity for balanced tracker portfolios in South Africa, especially as a core part of a portfolio, to which actively managed satellite portfolios can be added.
The primary aim of a core portfolio is to match the risk or liability component of the investment requirement, and not to “chase” returns. Once the risk and liability have been covered, the investor can turn his attention to looking for return opportunities in an unconstrained manner in the satellite portfolios.
In addition to the well-known cost and transparency advantages that balanced tracker portfolios offer over actively managed alternatives, Visser says “we believe that consistency in exposure to the right asset classes over time (thus not following the latest fad) removes the emotional human interface from the investment decision making process in the core part of the portfolio.
“This can be done in a very efficient and cost-effective way that benefits the end investor in the long term.”
10X Investments
The 10X Investments balanced tracker portfolio has been in existence since 2008 and provides lifestage solutions for occupational retirement fund members. It is now available for individuals through RAs and preservation funds. 10X’s total cost of investing, which includes administration and investment management, ranges between 0.5 percent a year for medium to large companies and around one percent a year for small companies and individuals. (The average cost of retirement products is about three percent a year, with some life assurance products as high as four or five percent a year.)
Nathan says the portfolios are modelled on your age and years to retirement. The longer your time to retirement, the higher the allocation to equities – as the asset class with the highest expected long-term returns – in your portfolio. The shorter your time to retirement, the greater the focus on capital protection, by reducing your exposure to equities.
The exposure to the various asset classes is all done on a passive basis, with the various classes tracking various indices.
10X Investments uses its own portfolios except for the foreign exposure component, where it includes the Deutsche Bank rand-denominated dbx global tracker fund.
Nathan says everything is done to keep costs to a minimum, even to the extent that his company will not pay commissions to financial advisers. The company deals only with advisers who charge their clients directly for their advice. Apart from that, individuals and retirement funds can approach 10X Investments directly for products.
He says 10X Investments reports directly to clients, providing simple but complete information – including projected values and replacement ratios at retirement – which is available online.
There are 10 lifestage investment portfolios, with the allocation based on back-testing the various asset classes back to 1900, through which you move seamlessly and without additional cost as you approach retirement.
In the build-up stage of your retirement saving, the asset allocation weightings are 55 percent in South African equities, 15 percent in international equities, five percent in South African property and 25 percent in South African bonds and cash. When you have less than 10 years to go to retirement, the equity weighting is reduced each year and the bond/cash weighting is increased. At a year before retirement, the portfolio is about 20 percent in equities and 80 percent in bonds and cash. Investors approaching retirement can select a higher-risk portfolio by increasing their retirement age.
The local equity component tracks the Deutsche Bank 10X SA Equity Index (a modification of the All Share index), the local bond component tracks a combination of inflation-linked bonds and all-bond indices, the property component tracks the FTSE/JSE SA Listed Property index, the cash component tracks the Alexander Forbes Short-Term Fixed Interest index, and the international equity component tracks the MSCI World index.
Nathan says members of 10X Investments products are not given individual investment choice because most investors are not sufficiently informed to make appropriate investment decisions over their working life. Retirement investors need a sensible, low-cost solution rather than choice. Choice also adds to costs, which reduce returns.
He says that once choice is offered, particularly when it includes actively managed funds, high costs immediately come into play, reducing the returns you receive to very little or nothing.
He points out that for every one percent you save in costs you can add 30 percent to your final value after 40 years. Research shows that low costs are the most dependable indicator of future performance. Invariably, low-cost funds produce better long-term returns than high-cost funds.
THE MANY GUISES OF BALANCED PORTFOLIOS
There is a confusing array of balanced or flexible asset allocation investment portfolios available, ranging from those listed as collective investment schemes (CISs) through to balanced portfolios provided by the life assurance industry in which part or all of your capital and even some or all of your returns are guaranteed.
And to complicate matters further, some come as a package deal within a product such as a retirement annuity.
You need to establish which product and which investment portfolio is right for you. The issues you need to take into account include:
Your aims
Most people divide their savings into retirement savings and discretionary savings for a whole array of objectives, ranging from the education of children to a round-the-world trip. With retirement savings you are forced by law to take a comparatively conservative approach to how your savings are invested to reduce risk, but with your discretionary savings you can take any risk you like. For non-essentials such as a round-the-world trip you can afford risk, but for the education of your children you need to take less risk, so a balanced portfolio is probably a better bet.
Another big investment division for most people is whether they are seeking capital growth and are prepared to take some risk or whether they want to protect their accumulated capital while using it to provide a stable and sustainable income, mainly in retirement, in which case they need to take lower investment risk.
The issue is to understand your savings targets and to accept there are different approaches. For example, if you saved all your money in a bank account from age 20, after inflation and after tax you will be going backwards. You need to take some risk to ensure that your savings will grow. A good way to ameliorate risk is to consider balanced/flexible investment portfolios.
Your investment risks
Balanced asset allocation portfolios come in many different guises with different levels of investment risk. You need to understand some of the options.
The most important are portfolios that must abide by regulation 28 of the Pension Funds Act to ensure your savings are prudentially invested.
Prudential funds are divided into sub-sectors according to their risk level, mainly determined by how much of the fund portfolio is invested in equities. The higher the equity percentage, up to the allowable maximum of 75 percent, the more aggressive a fund is considered. So if you are young a more aggressive prudential portfolio will be more suitable for your retirement savings, because you have the time to ride out market volatility.
But as you approach retirement and move into retirement, most people are better off with a less volatile, lower-equity prudential balanced portfolio.
With discretionary money, even when saving for non-essential round-the-world holidays, there will be a balanced portfolio for you. Outside the prudential portfolios there is a wide range of risk/return offerings, including:
* Total discretion. The portfolio manager has the discretion to use the various asset classes as he or she sees fit to achieve the best results. The manager, for example, can take high risks by investing as much as 100 percent of your savings in equities.
* Targeted returns. These portfolios aim at providing a return above a certain absolute benchmark, normally a percentage return above inflation. This does not mean the target will be achieved. In fact, the higher the target, the less likely it is that it will be achieved, particularly over the shorter term.
* Downside protection. These portfolios aim at giving you maximum returns while protecting you against the value of your savings dropping significantly in times of any investment market turmoil.
Your legal wrapper choices
You have a choice of various legal wrappers, for example between tax-incentivised retirement saving products and non-retirement savings using balanced portfolio investment products. Then you get balanced portfolio choices among CISs (unit trust funds and exchange traded funds) and life assurance endowments, which are available for both discretionary savings and for retirement savings. CISs and life assurance products are governed by different sets of legislation.
The differences include:
* Ownership. When you invest in a CIS you own the assets in your name and you take all the investment risk. With a life assurance product you hand over your savings to the life company and in return it promises you certain outcomes. The outcomes can range from providing you with a return related to actual market conditions through to guaranteeing your capital and providing a pre-determined income. Life assurance companies are required to hold reserves to ensure they can meet their promises to you. CISs do not have to hold reserves because they make no promises and provide no guarantees.
* Contractual conditions. Life assurance products come with contractual conditions to maintain contributions and honour investment periods. If you break the conditions, even through no fault of your own – such as losing your job and being unable to maintain your contributions – you can be penalised. On any life product purchased before January 1, 2009, the penalty can be as high as 30 percent of your accumulated savings. The penalty is up to 15 percent on any contract entered into after January 1, 2009.
You are not contracted to contributions or investment periods with CISs, unless the investments are held in a life assurance policy.
* Guarantees. CIS products aim at providing certain outcomes, such as a return above inflation, but they cannot promise or guarantee the outcome. Life assurance companies, however, can and do offer guarantees. The best example is provided by annuities (pension products). You take the full risk of insuring a pension for life with an investment-linked living annuity, which uses mainly collective investment schemes as underlying investments. With a life assurance guaranteed annuity you are guaranteed that you will receive a pension for life at a predetermined amount that may be variable – for example, increasing in line with inflation. You will, however, pay an explicit or an implicit fee for the guarantees.
However, investment products have become increasingly complex, with life assurance policies being used to package unit trust funds as underlying investments. A good example is the retirement annuity (RA) market. RAs, which are broadly divided into unit trust RAs and life assurance RAs, have different legal structures, which you need to take into account.
Generally, life assurance RAs are the ones that come with the funnies, such as contractual periods and penalties for not meeting the one-sided contracts.
There is also a lot of mixing and matching. The main choices are:
* CIS RAs offered by a single management company, which restrict you to investments in the company’s underlying suite of unit trust funds. You are normally allowed to switch between the unit trust funds of a single management company free of charge. The choice of the underlying unit trust funds is yours to make.
* Linked-investment service providers (Lisps) also offer mainly CISs, but expand your choice to funds offered by numerous management companies. Choice might even include listed securities. You also have the ability to switch between the underlying investments.
* Life assurance RAs, which come either with market-related portfolios or with fully or partially guaranteed portfolios. Balanced funds can be offered under both, but with market-related portfolios you are also given specific underlying investment choice. Most life assurance balanced funds normally centre on smooth/stable bonus portfolios with full or partial capital guarantees.
Your tax outcomes
There are different tax consequences of using balanced portfolios within different products. These include:
* Retirement funds. Within limits, your contributions can be deducted from your taxable income; any lump sum you take at retirement is favourably taxed, with an initial exemption; investment returns are tax-free until withdrawn as a pension benefit; and no capital gains tax (CGT) applies.
* Life assurance products. No tax is payable in your hands on the receipt of benefits, because the life assurance company pays income tax at an effective rate of 30 percent and CGT at an effective rate of 7.5 percent. This means that people on tax brackets of 30 percent or less are disadvantaged. The tax rates may appear attractive to people in higher tax brackets but you lose annual interest and CGT exemptions; and CGT is calculated on every trade within the portfolio, which means that if a portfolio is extensively traded you could pay more tax indirectly than you otherwise would have paid.
* CISs. Interest income is taxed in the year in which it accrues – not whether you withdraw the returns – at your marginal rate of income tax, less any annual tax exemptions. CGT is only applicable when you cash in your investments.
Your costs
Costs are increasingly becoming a major factor in making investment choices. Costs have a major impact on your investments, but the problem is that costs are often opaque and when declared often do not include all the costs.
The issue is complicated by the fact that there is no industry standard for declaring costs. The life assurance industry uses what is called a reduction in yield calculation, which shows by how much your investment returns are reduced each year. The collective investment industry uses what is called total expense ratios (TERs), which tell you what the annual costs are.
Both structures, however, do not include all costs. For example, Lisp administration costs, as well as any commissions or advice fees, may or may not be included.
Costs may include initial costs, annual costs, costs based on a percentage of your assets, a percentage of your returns, fixed rand costs, withdrawal costs, switching costs and guarantee fees. While one instrument may appear cheaper than another or have seemingly better performance, the reason may be the consequence of what costs are included or ignored.
Generally, the more you invest and the longer your investment term, the lower the effect of costs will be.
You need to ensure that all costs are itemised and you receive a calculation that shows the impact of costs on your returns over the full term of your investment.
This article was first published in the 2nd quarter 2011 edition of Personal Finance magazine.