Guaranteed products – not that wonderful

Billions are invested annually in guaranteed products because some investors don't like investment risk. Inflows into these products increase dramatically after a stock market crash as investors don't want to suffer losses again. Unfortunately, this is precisely the time when you don't need a guarantee because it is unlikely that the market will collapse again so soon after a crash. Many of these guaranteed products offer a stock market return with the benefit of capital protection. This seems to be a great deal as you invest in the stock market without the risks. The problem is that most of your stock market growth comes from dividends which you don't earn with guaranteed products.

How guaranteed products are structured

There are hundreds of different types of guaranteed products, so for this article I will focus on five-year products that offer a stock market investment with a capital guarantee. This type of product will usually offer you a 100% capital guarantee and link your investment growth to the performance of a stock market index or something similar. Your performance is calculated by the movement of the index over the five-year period. As an example, if the All Share Index starts at 26 000 and grows to 35 000 after five years, the index performance is 34%. Most guaranteed products will not give you 100% of the index growth, they will usually limit your growth to 75% of the index performance. For the investment in this example your total return would be 25.5% over the five years. It is important to note this is a total return and not an annual return.

Why not use these products?

If you are prepared to lock away your capital for five years, you really don't need a capital guarantee. If you are really risk averse, you could take 25% of your capital and invest it in the index yourself (via an ETF) and place the balance in a five-year RSA retail savings bond. In the history of our stock market to date, you would not have lost money with this type of investment. If your retail bond only gives you 8% per year, you would get all your capital back plus 10% growth just from the bond. In addition you can get anything from 0% to 50% additional growth from the index ETF. This means you could have between 110% and 160% growth for a five-year investment with no lock-ins. If you were to split the capital 50:50 between the bonds and the index, it is still unlikely that you would lose money over five years.

If you look at Graph A below, it shows what type of growth you would have had if you had started investing in the JSE on 1 January 1960 and ended in April 2009. The three components of this growth were: inflation, dividends and capital growth. As you can see, dividends contribute more than 60% of your real growth from shares where real growth is the return above inflation. Most guaranteed products don't give you the dividend growth. This means you are sacrificing more than 60% of your potential equity returns. Dividends are such an important part of share price growth that you would be better off not investing in shares if you don't get the dividends because the compounding effect of dividends will protect you from capital losses over time.

Because a guaranteed product needs to run for a fixed term, you will be heavily penalised if you decide to draw your capital before the term expires. You will lose the benefit of your capital guarantee and you might end up losing some of your current market value as the product provider needs to trade a small illiquid investment which means big dealing costs.

My final concern is the value of the guarantee. You need to ensure that the company offering the actual guarantee is financially sound. As we saw in the financial crisis, you cannot simply rely on the fact that a large financial institution provides the guarantee, it could collapse and leave your investment worthless.

Are there any good guaranteed products?

As you may have gathered, I am not a fan of guaranteed products but there are special situations where they can be helpful. Firstly, the term of any guaranteed product should not be longer than three years. If you want to invest in shares you need to hold them for five years at least. If this is not possible then a guaranteed product makes perfect sense.

A guarantee also makes sense if you are investing in a high-risk market (eg, Russian or Brazilian shares) and you are not in a position to monitor your investment properly. I would naturally argue that you should avoid an investment that you cannot monitor properly but if you are going to invest anyway, then try to use a guarantee.

What else this graph tells us

The analysis and resulting graph was given to me by Cannon Asset Managers and provides some very interesting information that should prove useful to all equity investors. The analysis was done to argue the case for value investing and thus shows the impact of dividends on equity returns over time. It highlighted dividends because the shares that are targeted by value investors, such as Cannon, usually have a good dividend yield. To me, the graph also shows the benefits of long-term equity investments. If you are an equity investor and you only buy the index and re-invest your dividends, it is unlikely that you will lose money in real terms if you invest for periods of eight years or longer. From the graph you can see that there was only eight-year period since January 1960 where you would have lost money in real terms, and that was if you invested at the market peak in the late 1960s and sold your shares in the late 1970s.

The graph also shows the real dangers of inflation, which I feel poses a far bigger threat to long-term savings than stock market risk. Because the effects of inflation are not dramatic, we don't really feel them over one or two-year periods. It is only once you start seeing the compounded effects of inflation (the top section of the graph) that you realise this is the aspect of your investments that should concern you the most.

* Warren Ingram, CFP, has been advising people about their money management since 1996. He is a director of Galileo Capital, www.galileocapital.co.za.

Are there specific Money Matters you would like Warren Ingram to cover?

Write to him at Warren@galileocapital.co.za

This article first appeared on Moneyweb and can be viewed at:
http://www.moneyweb.co.za/mw/view/mw/en/page311172?oid=333242&sn=2009 Detail&pid=287226

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