Could our current status quo be déjà vu? Have we been here before? The answer is no. Since the formation of our democracy, we have not seen violence, looting and riots of this nature. While it’s impossible to comprehend and rationalise what we are going through as families, communities and as a country, one thing that we know to be true, that we will survive this and we will rebuild this nation.

When the dust settles and we sit at home and reflect, we find ourselves wondering about the future and we worry. We worry about when/how life will ever return to ‘normal’. We worry about the health of our family, friends, and colleagues. We worry about the economy and work. We worry about money and our savings. While we are not able to provide guidance on all these worries, we can provide more context around money, savings, and investments.

Markets keep moving up and down, and so too do investor’s emotions. This is understandable – it is, after all, our hard-earned money we’re talking about. It’s only natural that many investors have now grown tired of stomaching this unpredictable rollercoaster ride and would much rather prefer to place their feet on solid ground. In the world of investments, the rollercoaster ride is equities and cash is often seen as the solid ground.

How will the latest unrest in the country affect my investments?

The big question across the country is around the issue of the medium-term economic impact and where to from here? We have seen the Rand weaken against major currencies as the market pulls away from South Africa in times like this. It is too early to assess if the current events will have a long-lasting negative impact on the South African economy, but we believe immediate evidence points to a short-term impact (assuming officials are successful at containing the situation).

The reality is that, in times of stress and uncertainty, markets and currencies can move sharply. Even so, these types of events create uncertainty and often leave investors with the urge to do something.

The below graph shows the 15 worst days on the JSE (the red bars) since the end of June 1995 and how the local market reacted after the drawdown. The blue bars show the 12-month returns investors experienced after the worst day and the green bars show the five-year annualised returns after the drawdown.

As an example, during the 2008 global financial crisis on 06/10/2008, there was a loss of -7.12% for the day but the subsequent one-year return amounted to 22.41% and the annualised five-year return was 19.24%.

Despite the current negativity and volatility, investors who are in Equities are advised to retain their exposure to this asset class since this is likely an unplanned short-term phenomenon that should not detract from the long-term value of equities.

If the impact is short-term, price declines may produce buying opportunities. Warren Buffett, chairman and CEO of Berkshire Hathaway, said “you don’t buy or sell a business based on today’s headlines. If the market gives you a chance to buy something you like and you can buy it even cheaper, then it’s your good luck.”

Current portfolio positioning

Current events and the possible volatility that might be experienced in the coming weeks once again highlights the importance of effective portfolio management, asset class diversification and pricing in risk to protect capital.

Client portfolios managed by Morningstar Investment Management are well diversified between strategies and asset classes and we are confident in our current positioning. Your portfolios are well diversified against SA specific risks.

Morningstar is keeping a close eye on all the above and actively managing your money. Our investment team has built portfolios that we believe are designed to not only protect investor capital in tough periods but more importantly to provide long term growth of investor capital.

This means that short-term market moves and doom and gloom media headlines, rarely (if ever) rattle our cages and we focus our energy on areas where we can add value.

What should investors do? Remain calm. Remember: time in the market is superior to timing the market.

At this stage, the best thing investors can do is to remain patient. Investing in the equity market is a long-term pursuit and is best used to reach long-term goals such as retirement. As the saying goes – a river cuts through a rock, not because of its power, but its persistence.

While noise and speculation can act as an emotional rollercoaster, your goals are unlikely to have materially changed and, therefore, your plan shouldn’t either. This is where we need to be balanced. A big part of wealth creation is avoiding the biggest mistakes and disinvesting into cash now is one of the most well-known actions to avoid.

While the consideration to grab the closest cash lifejacket, jump ship and move all your assets to cash is an understandable response to recession fears, it is unlikely to be in investors best interests.

In closing

As investors, we too often redirect our attention away from the destination to the journey when faced with a lot of outside noise. Much like in other walks of life, we can lose focus, making us susceptible to capitulation or giving up at the moments when fortitude and resolve pay off most.

Patiently allocating to assets that will help you achieve your financial goals should remain key. So, if you catch yourself getting down about the state of our economy, lockdown or speculation around government policies or trying to predict what is next, always remember what is in your control and what is not.

The habit of investing is one of the best habits you have within your control. Doing nothing and staying the course is still a decision. It is often during these difficult times that we have the greatest opportunity to add value for our clients, acting rationally when others struggle to do so.

Providence Wealth would like to send thoughts of strength and support to those who need it now.

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

It’s interesting how the value of the rand can influence our perception of the value of our country. A strong rand, when compared to the dollar, often makes us feel better about the state of affairs in South Africa. When the value of the rand climbs, so does our optimism about the growth and recovery of the country, while a weak currency fires up all the negative sentiment we read about in the press.

With that said, it’s not all doom and gloom and South Africans can find some reprieve in knowing that the value of our currency is only partially affected by South African specific factors. In the following article, we discuss the different factors that can influence the value of our local currency.

In recent years, the South African rand has been on the back foot against major currencies, with investors being extra cautious due to the many headwinds and political infighting that frequently dominates news headlines. Investors simply can’t ignore that the country has subdued growth, a weak fiscal outlook, rising industrial and social tensions, and external vulnerabilities associated with the current account deficit, all of which support a weaker currency.¹

A research report² was written by the International Monetary Fund (IMF) wherein it looked at the main drivers that impact the Rand/Dollar exchange rate since the onset of the global financial crisis and the results are very interesting.

Rand volatility could be attributed to global macro-economic factors

The IMF’s research showed that the main driver behind the movement of the rand relates to global factors and macro-economic events in the U.S. In other words, the level/value of the rand is often influenced and determined by dollar movement (strength and/or weakness). Roughly 30% of all rand volatility could be attributed to global macro-economic factors which influenced the US dollar and hence the rand.

As a small, open, emerging market that makes up less than 1% of the world economy, we are more likely to be affected by what is happening globally rather than in our own country. This is further exacerbated by the fact that the rand is one of the most liquid and tradeable currencies when compared to other emerging market currencies globally. Often when there is global risk aversion (better known as a “risk-off trade”) and investors flock to safe-haven assets, the rand acts as a proxy for all assets perceived to be risky by global investors. This can often lead to the rand depreciating.

1 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
2 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.

Commodity price volatility is a key factor

A second finding was that commodity price volatility was a key factor that influenced rand/dollar volatility. Roughly 30% of the volatility of our currency was a result of commodity price volatility. Over the past year, we have seen a sharp rise in commodity prices of which South Africa has been a beneficiary.

South Africa is a net exporter of resources, and local exporters benefit from the rand weakness in that it makes the goods and services that we produce cheaper for foreigners and more attractive when compared to the goods and services available in other markets.

South Africa also imported a lot less in 2020, which has impacted our current account balance positively which, in turn, has been a factor causing the recent Rand strength.

Impact of domestic factors on the rand

The IMF’s research also looked at the impact of domestic factors on the currency. They found that neither domestic macro-economic surprises nor those originating from other emerging markets are statistically related to rand volatility. However, they did find that local political uncertainty is positively associated with rand volatility.

Purchasing Power Parity’s part

Of the many metrics used to determine the valuation of the rand against other major currencies, is the Purchasing Power Parity Index (PPP). PPP is an economic theory that compares the different currencies from countries across the globe through a “basket of goods” approach.

In 1986, The Economist created the Big Mac Index ³ to create a lighthearted way of showing PPP and whether currencies were cheap or expensive. The Big Mac Index uses a price of a Big Mac burger in the US (as a base) and then compares the price of a Big Mac burger in every other country (in its native currency) and then looks at the price differential.

According to the latest Big Mac Index data, the rand is very cheap compared to the US dollar. A Big Mac costs R33.50 rand in South Africa and US$5.66 in the United States. The implied exchange rate is 5.92. The difference between this and the actual exchange rate, 15.52, which suggests the South African rand is 61.9% undervalued.⁴

With that being said – it should also be pointed out that we do not believe the Rand to be 62% undervalued – this is merely a fun way of looking at relative currency strength or weakness versus the US dollar.

3 https://www.economist.com/big-mac-index
4 https://www.economist.com/big-mac-index

So, how should we go about working out a fair value for the rand?

Currencies can deviate significantly from fair value over time, however, over the long term, movements between currencies should reflect inflation differentials between two countries. Due to the relatively higher inflation environment in South Africa (especially compared to most developed markets), we would expect the rand to depreciate against most developed currencies in the long term.

Currencies can frequently deviate from purchasing power parity over time. Extreme examples include the height of the commodities boom in 2005 and 2006 when the rand reached R6 to the US dollar. Following the removal of previous Finance Minister Nhlanhla Nene (in late 2015 and early 2016) the rand reached around R17 to the US dollar.

What should be apparent, however, is the movement in the exchange rate following these events. In almost all cases, the exchange rate moved back to a value that would be regarded as fair when judged according to PPP. That is not to say that currencies do not stay cheap or expensive for long periods of time. Idiosyncratic events may cause currencies to deviate from fair value for extended periods, however, currencies tend to move back to levels reflective of inflation differentials in the long term.

As can be seen in the below graph, the rand is currently undervalued on a Purchasing Power Parity basis.

Work done by the capital markets team at Morningstar supports the view that the Rand remains undervalued compared to the US dollar. It is also worth remembering that the rand never really trades at fair value. Historically, the rand moved in big swings from being expensive to being cheap and each time shooting through fair value.

Where does that leave us?

While the rand (at roughly R14/$) is undervalued/cheap, we don’t believe the economic data supports a materially stronger rand. Over time the inflation and growth differentials between South Africa and our developed counterparts support a depreciating currency. While the commodity cycle and US economic factors favour a firmer rand for now, we do expect that in a 10-year horizon the rand is likely to depreciate from these levels.

We are often asked the question, “Is this the time to be taking money offshore given where the Rand is?” and the best way to answer that is to quote Howard Marks who said, “This is not the time but it is a time”. The decision to invest offshore should be based on the investment opportunity. While the value of the currency does play a factor, we would encourage investors not to try to time the currency.

The above factors once again emphasise the need for investors to remain patient, stay the course and avoid making investment decisions in a panic due to gloomy news headlines. This would include articles forecasting which direction the rand is heading. Previous experience has taught us that these forecasts are seldom accurate. It is during these challenging investment times that we should remove emotions from our investment decision-making process and focus on the fundamentals.

In Conclusion

Over decades of evidence and through the investment literature there is one golden thread –time in the market remains superior to timing the market.

Ask yourself this: “Given where I am now, what actions move me closer to my long-term goals?” “Would an investment change align with the original investment plan for reaching well-defined goals?” These are different questions than, “What do I wish I had done last month?”.

We believe that investing is a long-term pursuit, patiently allocating to assets that will help you achieve your investment goals.

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

It is hard to imagine that only a year ago, markets hit rock bottom and investors were worried about how the rest of 2020 would pan out. Across the globe, investors were faced with questions such as – will valuations decline even further? How and when will markets recover? Is it perhaps time to deploy cash into the market? Should we disinvest and wait for better days? Should we sit on our hands and do nothing?

Today we are facing a different dilemma. Markets are at an all-time high. In a short space of time, everything has changed. The rollout of Covid-19 vaccines and associated hopes for imminent economic recovery, along with unprecedented fiscal and monetary support from governments and central banks around the world, has driven equity markets beyond or close to record highs of late. With stock market valuations at historically high levels speculation about a market bubble has been rekindled.

The Price-to-Earnings (P/E) ratio as a measure of valuation

Investors often look at a valuation in its most traditional form, also known as the P/E multiple. A P/E multiple (price to earnings ratio) gives investors an indication of what the market is willing to pay for every R1 of earnings generated. Setting aside the impact of short-term changes to profit, a high P/E ratio typically indicates the expectation and/or perception that a company could/would have good growth prospects, or less risk to profits, than the average company. Thus, a company with a proven long-term track record of growing profits would normally trade at a high P/E ratio and a company with low growth, or a patchy profit history, would trade at a lower P/E ratio.

While P/E is an incredibly good starting point to assess the valuation of a company or a market, many investors fail to look deeper.

Delving deeper into markets

The P/E ratio of the S&P 500 is trading at near-record highs. One could argue that it is, perhaps, a very blunt way to look at the world. It is important to unpack what drove the performance of the S&P 500 to these levels.

When analyzing the data depicted in the below two graphs, it is clear that most of the performance of the S&P 500 came from large FAANG stocks. [FAANG is an acronym referring to the stocks of the five most popular and best-performing American technology companies: Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google)].

Exhibit 1 depicts the cyclically adjusted P/E ratio for the US market.

There is no doubt that most of the large tech giants are good companies, with robust business models and incredible management teams. However, one must keep in mind the two tailwinds that existed – the first being record low interest rates for a prolonged period of time and the second being that most of these FAANG stocks were direct beneficiaries of lockdowns worldwide. Therefore, caution should be applied when assessing if they will continue to generate such exceptional performance indefinitely.

Looking at the opposite side of the coin – what about the other sectors that have not enjoyed such lucrative returns over the last number of years? Could the grass be greener on the other side but investors are not seeing it?

Is local still lekker?

On the local front, investors have enjoyed good returns from the JSE All Share index over the last few months. The question remains – will this continue or are we due for a correction? The truth is that nobody knows how long a rally can and/or will continue.

What we do know is that emerging markets have been severely out of favour for the last decade or so. Within the emerging markets group, South Africa has been out of favour for such an extended period that both local and foreign investors seem to have lost hope.

The recent rally could be the market playing catch up coupled with a positive global backdrop for South African equities. The domestic economy may well continue to face structural headwinds going forward but could also recover from depressed levels gradually as activity normalises and accommodative interest rates stimulate incremental demand.

While we contemplate whether this partial recovery will be enough to generate satisfactory returns from domestic shares (from current price levels), there is the possibility for a more pronounced and sustained recovery in activity and sentiment as the global economy reflates and South Africa receives a natural slice of emerging market flows.

At Morningstar, we believe some areas in the domestic market still offer a very good opportunity and has lagged in the recent recovery. Financials are a good example of such an area.

What is the alternative?

A few years ago, South African investors could generate a real return (a return over and above inflation) of about 3%, by simply remaining in cash. It was an easy choice for those that did not want to expose themselves to equity market risk. Today, this picture is quite different. Cash rates are at historic lows with returns from money market funds sitting at about 4% and there is not much yield either if you look at developed markets.

Long dated South African Government bonds on the other hand still offer very attractive yields and continue to make up an overweight percentage within the Morningstar Portfolios. As far as equity risk is concerned, we continue to assess all individual opportunities through a valuation lens as well as the fundamental risk associated with each asset class. We continue to find value in areas of the market like UK Equities, European Equities, S.A. Financials, Energy etc.

Getting back to the question, are markets in a bubble at the moment?

At Morningstar, we believe a blunt expression like this one is probably foolish. The truth is there is always a bubble somewhere, whether it is Tesla, Bitcoin or the FAANGs. The best you can do is to continue to assess opportunities as they arise and patiently allocate money to the areas that will best serve your investment goals.

Although the obvious opportunity set has declined in equity markets over the last couple of months, there is still ample opportunity for investors who are willing to look a little deeper.

Debra Slabber, CFA®

Portfolio Specialist

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

*This piece was originally distributed via Morningstar Inc in the United States. We believe it has interesting perspectives for S.A. advisers.

Bitcoin investors have been on a wild ride lately. After dropping about 74% in 2018, the digital currency nearly doubled in price in 2019, and then nearly quadrupled during 2020. Trading volumes have also skyrocketed as individual investors have embraced cryptocurrencies through commission-free trading platforms such as Robinhood.

Originally conceived as a digital, encrypted alternative to traditional currencies controlled by central banks, bitcoin has also been attracting more interest from mainstream investors. For example, BlackRock recently added prospectus language giving three of its mutual funds the flexibility to invest in bitcoin futures. In late 2020, insurance provider MassMutual purchased $100 million in bitcoin in late 2020 for its investment portfolio. And in recent months, several high-profile institutional investors – including Miller Value Partners’ Bill Miller, BlackRock’s Rick Rieder, and Tudor Investment’s Paul Tudor Jones – have touted bitcoin as long-term investment with significant upside potential, even after its previous surge.

There are some arguments in favour of bitcoin as an investment, but there are also reasons to be sceptical. Overall, it has enough negatives that I would hesitate to carve out more than a small fraction of a portfolio for bitcoin.

The Case for Bitcoin

Bitcoin has been hailed as a transformative technology that promises to revolutionize the entire landscape of money and payments. In fact, the enthusiasm surrounding bitcoin is so intense that it borders on religious fervour. Bitcoin itself has even been compared with a religion, with its own set of doctrines, sacred texts, acolytes, and rituals.

Bitcoin proponents often argue that because only 21 million bitcoins can ever be mined, a permanently limited supply should support its value. It’s often viewed as an alternative to gold, which also has a limited supply but has a more definable intrinsic worth because it’s used for jewellery, industrial applications, and as a tangible store of value. Cryptocurrencies like bitcoin could potentially benefit from increased demand for secure international transactions, low-cost banking, and anonymous micropayments or general-purpose payments. The network effect also comes into play with bitcoin, as growth in usage should (theoretically) increase its value at an exponential rate.

Bitcoin’s limited supply also makes it a potential hedge against long-term inflationary pressures. With the Federal Reserve printing money at an unprecedented rate, the market is currently pricing in a five-year breakeven inflation rate of 2.18%, which would be higher than the unusually benign inflation we’ve seen in recent years. Bitcoin has often (though not always) historically had a negative correlation with the U.S. dollar, which started losing ground in March 2020 after a generally strong upward trend over the previous decade. Bitcoin’s future value partly depends on widespread acceptance and usage as an alternative currency. Unlike traditional currencies, it’s not controlled by central governments. In that sense, it’s the ultimate insurance policy against weakness in the U.S. dollar or a collapse in mainstream financial systems.

The Case Against Bitcoin

But there are reasons to be sceptical. As a virtual asset that doesn’t generate cash flows, bitcoin has no intrinsic value. Its value depends largely on what people are willing to pay. When Guggenheim’s Scott Minerd was quoted in December 2020 claiming bitcoin could be worth as much as $400,000, bitcoin prices quickly escalated. But without a strong foundation to support an underlying value, asset prices can rapidly drop.

That’s exactly what happened in 2018, when the CMBI Bitcoin TR index dropped 74%. More recently, bitcoin’s price shed nearly 30% from its peak on Jan. 8 until briefly dropping below $30,000 on Jan. 27, 2021. Even intra-day pricing tends toward the extreme, with prices often swinging by double-digit percentages within the same trading day. These sharp price moves mean bitcoin owners must be prepared to “HODL” – hold on for dear life.

Bitcoin is often described as digital gold, but it hasn’t held up particularly well during periods of market crisis. In the fourth quarter of 2018, for example, bitcoin lost about 44% of its value, compared with about 14% for the broader market. When the novel coronavirus roiled the market from Feb. 19 through March 23, 2020, bitcoin lost about 38%, compared with 34.5% for Morningstar’s U.S. Market index. During weeks when the overall equity market posted negative total returns (over the period from August 2010 through the end of 2020), bitcoin notched positive results only about half of the time.

As mentioned above, bitcoin proponents often argue that limited supply should create a floor for bitcoin’s value. But while the supply of bitcoin itself is limited, there’s nothing preventing competing cryptocurrencies from emerging. There are already numerous bitcoin alternatives available, including Ethereum, Litecoin, Cardano, Bitcoin Cash, and Lumens, to name a few.

Fees and transaction costs are another negative. Coinbase, one of the most popular platforms for buying bitcoin, charges a spread of 0.5% plus a fixed or variable fee (whichever is greater) based on the investor’s location and method of payment. For U.S.-based investors, Coinbase charges fees of at least 1.49% (for purchases made through a bank account or Coinbase wallet) or 3.99% (for purchases made through a debit card). Fees for small-dollar purchases can be considerably higher. However, Coinbase doesn’t charge additional fees for the hosting and storage required to keep bitcoin assets protected from digital theft or other losses.

Accredited investors can also buy bitcoin through Grayscale Bitcoin Trust, an exchange-traded fund structured as a grantor trust. The fund, which has been operating since 2014, charges a 2% annual fee, which also covers storage costs. It has limitations on redemptions, making it impractical for investors who may need to make withdrawals. The fund also typically sells at a premium to bitcoin prices and doesn’t track the currency perfectly. Over the past five years, for example, the trust has posted an annualized market return of 115.3%, compared with 135.3% for the underlying index.

A competing firm recently started operating Osprey Bitcoin Trust, which is currently available as a private placement for accredited investors with a lower management fee of about 0.5%. However, investors are subject to a 12-month lockup period, compared with six months for the Grayscale offering.

Role in Portfolio

Bitcoin can play a role in diversifying a portfolio, but the impact of adding various weightings varies depending on the time period. To quantify this, I looked at the impact of adding different percentages of bitcoin to an all-equity portfolio.

Over the trailing three-year period ended in 2020, bitcoin’s meteoric rise could lead to a simple conclusion: The more, the better. Bitcoin showed more than four times as much volatility (as measured by standard deviation) as equity market indexes over the period. But because of its low correlation with the equity market, adding bitcoin didn’t increase volatility all that much. Even a 10% bitcoin weighting would have increased the portfolio’s standard deviation by a fairly moderate amount, as shown in the table below. From a portfolio perspective, higher returns more than offset the added volatility; Sharpe ratios increased in tandem with higher weightings in bitcoin.

The picture looks less favourable over the trailing 10-year period, though. Bitcoin’s standard deviation was more than 15 times that of the equity market, making it among the most-volatile assets in Morningstar’s database of 35,000-plus market indexes. As a result, both risk and returns increased with larger bitcoin weightings. Even a 1% weighting would have led to a sharp increase in standard deviation compared with an all-equity portfolio, as well as significantly worse drawdowns. Monthly rebalancing would have led to better risk-adjusted returns, but that approach might be impractical for many investors in light of bitcoin’s transaction costs.

Given the divergence in results over different time periods, deciding on an appropriate bitcoin weighting partly depends on whether you think the future will look more like the recent past, or more like the trailing 10-year period. Much of bitcoin’s eye-popping 10-year record owes to an off-the-charts runup from 2011 through 2013, when the CMBI Bitcoin TR index posted annualized returns of more than 1,000% per year, including a gain of more than 5,300% in 2013 alone. These gains may not be repeatable, partly because trading volumes in bitcoin have increased nearly 3,000-fold since 2014. On the positive side, volatility has significantly decreased, although bitcoin’s standard deviation remains more than four times higher than that of the broader equity market.

It’s also worth noting that as bitcoin moves to the mainstream, it’s becoming less valuable as a portfolio diversifier. As shown in the chart below, bitcoin has had fairly low correlations with most major asset classes over the past three years. Correlations have been trending up, though. In 2020, for example, bitcoin had a correlation coefficient of 0.68 versus the S&P 500, compared with 0.32 for the trailing three-year period. However, its negative correlation with the U.S. dollar has grown even more pronounced, making it a potentially valuable hedge against continued softness in the greenback.

Conclusion

Overall, I’m sceptical about the case for bitcoin as an investment asset. Its popularity with momentum investors and speculative buyers makes it prone to pricing bubbles that will eventually burst. It’s also nearly impossible to pin down what its underlying value should be. As mainstream investors increasingly embrace bitcoin, its value as a diversification tool is diminishing; as a result, there’s no guarantee that adding bitcoin will improve a portfolio’s risk-adjusted returns, especially to the same extent it did in the past. However, there are some compelling arguments in favor of bitcoin as an alternative currency and as a commodity that can help support new technologies, such as smart contracts and more-efficient financial transactions with built-in encryption. For that reason, bitcoin is probably best used in (very) small doses as a hedge against weakness in the dollar and major disruptions in the global financial system.

Note: This article has been updated to remove a reference to Guggenheim Macro Opportunities (GIOIX) seeking SEC approval to invest up to 10% of its assets in Grayscale Bitcoin Trust (GBTC). After the article went to press, we were informed that this is no longer the case. We also revised the article to clarify that Osprey Bitcoin Trust is currently available as a private placement.

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.

Amy C.Arnott, CFP

Portfolio Strategist

Morningstar Inc.

About the Morningstar Investment Management Group
Morningstar’s Investment Management group, through its investment advisory units, creates investment solutions that combine award-winning research and global resources with proprietary Morningstar data. Morningstar’s Investment Management group provides comprehensive retirement, investment advisory, and portfolio management services for financial institutions, plan sponsors, and advisers around the world.
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The seeming disconnect between the performance of financial markets versus that of economies across the globe has left many investors scratching their heads. We often get asked how is it possible for financial markets to increase in value, but the economy is shrinking?

It goes without saying that we live in extraordinary times. The South African economy had never faced such an abrupt cease in trade and/or economic activity as with the commencement of the nationwide lockdown on 27 March 2020. The same can be said for other economies around the globe. As economies started to reopen, many investors have been left scratching their heads – the recoil in financial markets painted a very different picture from the economic outlook.

It is not surprising that markets experienced some of the sharpest falls in asset prices during the first quarter of 2020. The JSE All Share Index lost more than 30% from the start of 2020 until 23 March 2020. What was surprising to see was the speed of the recovery hereafter – since 23 March 2020 (the bottom of the sell-off), the market is up more than 70% (as at February 2021) making COVID-19 seem like a mere short-term disruption.

The economy, however, tells a very different story, with one of the largest contractions in GDP ever recorded, coupled with sky-high unemployment numbers.

How are financial markets flourishing when economies are falling apart? Let’s have a look at financial markets in more detail, more specifically the equity market.

Equity market

The equity market is forward-looking and prices of stocks/shares/bonds (any listed liquid instrument’s) are determined by the supply and demand of investors. Investors that are buying these instruments are expecting positive outcomes looking forward. Sellers, on the other hand, expect the price of the stocks/shares/bonds to decrease in value.

So how do you know if you should be buying or selling? Ultimately, you need to consider the value of the company. The intrinsic value of a company can be estimated by taking its future expected earnings and discounting the future cash flow with an appropriate discount rate to ascertain what the value of those future earnings are worth now (or at the time one buys the listed equity).

The factor that has changed most notably in the above equation is the significant drop in interest rates – not only in South Africa but globally as well. With interest rates decreasing with 3% since the start of 2020, the discount rate being used to calculate the worth of future earnings is now significantly lower. This will result in future earnings being worth more today than before the interest rate cuts.

When the economy is slowing, the South African Reserve Bank (SARB) cuts interest rates to stimulate financial activity. This benefits businesses in that they enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, also leads to higher share prices¹. The reduced financing cost also increases future earnings figures.

Companies also have control over aspects that contribute to the current value of the company. Companies can use times of uncertainty as justification to cut their cost base and in doing so increase their bottom line/earnings. In other words, the leaner operational costs will result in higher expected future earnings.

In short, market crashes reset valuations of listed companies and provide investors with the chance to invest into opportunities that might not have been available, or an even an option previously due to prices being too high. This ‘opportunity’ buying cycle subsequently drives up market prices.

The last factor that can’t be ignored, and one that is especially important in the South African landscape, is that listed companies that sell products offshore are not reliant on how the South African economy performs. These shares are more broadly known as Rand Hedges (with the weaker Rand also working in their favour).

If one looks at every company listed on the South African stock exchange (the Johannesburg Stock Exchange or JSE), the majority of companies are not reliant on the South African economy to generate earnings. These are companies with business interests that are either predominantly outside of South Africa or entirely outside of South Africa.

In fact, 69% of the revenue generated by the top 40 companies listed on the JSE was generated from outside of South Africa for the 2019 calendar year². In essence, when you are investing in the South African equity market (as represented by the Top 40), only 31% of company revenues are reliant on the South African economy³.

This is possible due to the fact that some of the largest companies on our stock exchange are dual-listed companies. In other words, these companies are listed on more than one country’s stock exchange. For example – the BHP Group is listed on the London Stock Exchange as well as the Johannesburg Stock Exchange. While the BHP Group used to have operations in South Africa, currently the company does not generate any earnings in South Africa.

There are many similar examples on our stock market and most of these companies carry larger weightings in the index. We call these rand hedge shares. In short, if the rand weakens, it is a benefit to own these shares as they generate earnings in offshore currencies. So, as an investor, you are hedging your currency exposure even though you are investing in a South African listed equity.

Local government and economy

In contrast with forward-looking equity markets, Government GDP numbers are backwards-looking. GDP is the value of goods and services produced/rendered in a country during a certain period. It provides a snapshot of a country’s economy, and it is used to estimate the size of an economy and its growth rate.

Due to stringent lockdown rules in South Africa, several sectors came to a complete standstill and, therefore, did not contribute to growing our GDP rate. As an example, in South Africa, GDP numbers are highly dependent on mining, agriculture, manufacturing and construction (to name but a few) – most of which had to halt operations for quite some time. In addition, many of the companies that contribute to our GDP numbers are not listed entities but rather privately held and/or small business.

Unemployment is another number that has a different effect on economies when compared to listed companies. When a company retrenches employees it immediately lowers the expenses of the business and can potentially grow earnings (if income is unchanged) but the opposite is true for an economy. When someone is retrenched and they can’t find an alternative job, they move from being paid by a company to being paid by the economy and thus increasing the expenses of the government.

In closing

Investors too often redirect their attention away from the destination to the journey when faced with a lot of outside noise. Much like in other walks of life, we can lose focus, making us susceptible to capitulation or giving up at the moments when fortitude and resolve pay off most.

Patiently allocating to assets that will help you achieve your financial goals should remain key. So, if you catch yourself getting down about the state of our economy, or speculation around government policies or trying to predict what is next, always remember why you are investing in the first place.

There’s no doubt that the current market conditions are unsettling. It is at these moments that we would discourage investors from making changes that could harm their ability to reach their financial goals. It is often during these difficult times that we have the greatest opportunity to add value for our clients, acting rationally when others struggle to do so.

1 Source: https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/
2 Source: Ninety One Asset Management as at 31 May 2020
3 Source: Ninety One Asset Management as at 31 May 2020

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Our asset class convictions at a glance.

At a Glance

•  Markets continued to rally into year-end despite the dire economic backdrop.
• The fourth quarter of 2020 saw two major headaches subside, with the announcement of the rollout of a Covid-19 vaccine and U.S. election uncertainty drawing to a close.
• Markets were buoyed by lower than expected company default rates globally, aided by record-low borrowing costs and government support.
• A rising tide has lifted many boats, with some underlying developments being particularly noteworthy. For example, cyclical investments and value managers have made a comeback after an extended period of weakness.

2020 in summary

If we cast our minds back to March 2020, we were in the midst of one of the worst market drawdowns in history. It is hard to imagine that just nine months later we would report the JSE All Share Index ending the calendar year up by 7%. This positive return was not without volatility and extreme divergence between sectors and stocks.

If we look at general equity funds in South Africa, there was a 43.9% spread between the best and the worst-performing funds. The top performer, Fairtree Equity, reported a 19.8% return, while Nedgroup Investments Growth was the worst performer, declining by -24.1% for the year.

South African bonds, which has been a significant holding and area of high conviction for Morningstar, was the best performing domestic asset class for the year – despite downgrades to our sovereign credit rating and large outflows from foreigner investors.

Listed property had a very tough year, losing -34% in 2020, despite the rebound in the fourth quarter.

The 3% interest rate cut that came into effect in 2020 will impact money market and cash returns for investors going forward. Most investors have become comfortable with a 6% return from money market holdings, however, that number is set to almost halve in the coming year.

Globally, most markets, except for the FTSE 100 (the UK Market), ended the year in positive territory in US dollar terms. The most notable performance came from the tech-heavy Nasdaq 100, which increased by almost 50% for the year. The tech sector was a direct beneficiary of lockdown restrictions imposed globally due to the Covid-19 outbreak.

Global stocks, corporate bonds, real estate, gold, commodities, and even bitcoin have all moved higher and delivered positive performance.

The wave of “good news” comes with many fascinating and constructive sub-plots. One of the most interesting happened in the fourth quarter of 2020, where small-cap value stocks bucked a multi-year trend to join the winner’s list. This was partly marked by President-elect Biden’s victory (the so-called blue wave) but is also a vision for life after lockdowns – with the reopening of the economy considered a positive for economically sensitive and cyclical stocks.

Company defaults and bankruptcies also remain low globally, defying the doomsayers, supported by record stimulus and the cheapest borrowing rates ever seen.

Where to from here?

At the heart of Morningstar’s investment process is our valuation-driven asset allocation. This process continually seeks the most undervalued assets, and in turn, avoids what we consider to be expensive. We continue to search the investible universe for such opportunities and calibrate the possibilities on a risk-reward basis. We then build portfolios to express our best views to ensure that clients who remain invested will reap the benefits over the long term.

The current opportunity set is exciting. Even though markets rallied recently, one must remember that the performance within markets is incredibly divergent. For example, only a third of shares on the ALSI ended in positive territory for 2020.

Below is a high-level view of our asset class convictions and areas of the market where we are seeing opportunity:

Asset Class Conviction Monitor

Within our domestic portfolios, we have reduced our cash allocations in favour of South African equities and South African bonds. While listed property is looking attractive on a valuation basis, we are cognizant of risk and therefore we currently have limited exposure to this asset class.

For our Regulation 28 compliant portfolios, we remain fully invested offshore. While we may be entering a period of possible rand strength, we believe that long term investors will benefit from not only the diversification that global exposure brings to portfolios, but more importantly, the investment opportunities we have accessed via our global exposure.

Conscious of the fact that the South African investment universe has shrunk meaningfully over the past decade and there is a limited subset of investable industries, we look at our global holdings and local holdings together to ensure that we have high conviction in all of the assets that we own, according to our capital markets valuation framework.

Within our global portfolios, we believe that US large-cap equities are currently overvalued; however, we see good investment opportunities in areas outside of the US, namely UK Equities, Emerging Market Equities (especially Korea and Mexico) and Japan. Within US equities, we do see value in certain sectors such as energy and financials.

Looking to the future, investors must consider the risks they can’t see or at least those they haven’t given weight to. Above all else, investors need to weigh the valuations they are paying, as we have seen extreme divergences that present both an opportunity and a risk. While we have exposure to areas of the market where we are seeing attractive opportunities, our portfolios remain defensively positioned and are constructed to ensure that risk is considered and there is a balanced exposure to both growth and income assets.

We remain confident that our positions are in the best interests of our clients – acknowledging tomorrow’s challenges and working towards a prosperous 2021 with good financial decision making.

Debra Slabber, CFA®

Portfolio Specialist

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Who would have thought we would kick off 2021 in almost the same manner as 2020? Even though we were all hopeful that 2021 would start on better footing, numerous countries are still in lockdown, South Africa is fighting against its second surge of Covid-19 infections and economies worldwide continue to struggle. For humanity, we gladly waved goodbye to 2020, but for markets, we have seen a period of surprising benefit and near-record highs.

Global and local equities, bonds, gold, commodities, and even bitcoin have all moved forward and delivered positive performance despite struggling economies, widespread job losses and the biggest contraction in almost 90 years.

The final quarter of 2020 was strong by historical standards. Investor sentiment had been lifted by the news of the rollout of a vaccine worldwide alongside the perception of greater political stability.

In an article I wrote at the end of 2020, I used the analogy of a rollercoaster ride to describe the year – not only from a market perspective but especially from an emotional perspective. 2020 marked one of the most severe sell-offs in market history with three of the worst trading days recorded (historically) in March alone. With that being said, we also experienced the shortest bear market recorded (spanning over just 33 days) with most markets now sitting at all-time highs.

The one thing that 2020 highlighted again was our behavioural biases, exposing our good and bad traits when it comes to investing.

Let’s look at some of the lessons learnt in 2020 that will be worth remembering in 2021 and beyond.

1. Markets cannot be timed

Let’s say, hypothetically, you had anticipated that there was going to be a global pandemic, which you know would scare investors across the globe, resulting in sharp declines in the global stock markets, and you decided to withdraw your investment(s). Even with this knowledge, it would have been extremely difficult to predict the timing and strength of the rebound in the market. In this case, the severe downturn has (in many instances) corrected itself within a mere six months. Ultimately, you may very well still be sitting on the sidelines waiting for a better entry point to get back in.

It is critically important to remain invested, through good and bad times. Often the worst days in the market are followed by the best days. Unfortunately, you need to be invested through both the good and the bad to reap the benefits of gaining long-term market returns, which translate into wealth creation over time.

The graph below illustrates how missing a couple of good days in the market can severely impact your portfolio return over time.

2. Good follows bad, and vice versa

Although we have no way of knowing when a market crisis will start, we can be sure that it will end. Historically, a sharp market decline is generally followed by a strong rally. The timing of when that advance occurs is the only unknown variable at play.

South African equities experienced four of the largest one-day losses over a couple of weeks in March. In the below graph –

– The blue bars, show the 10 worst days on the JSE since the end of June 1995 and how the local market reacted after the drawdown.

– The red bars show the 12-month returns investors experienced after the worst day.

– The grey bars show the five-year annualised returns after the drawdown.

As an example, during the 2008 global financial crisis on 06/10/2008, there was a loss of -7.12% for the day but the subsequent one-year return amounted to 22.41%, with an annualised (average return per year) five-year return of 19.24% per year.

Yet another reason to remain invested throughout a crisis.

3. Optimism remains the only realism.

Humans have overcome incredible challenges throughout the centuries, and we are on our way to overcoming the latest challenge. Little did we realise just how much we would discover, explore, learn, and experience in a year that has brought with it so many different challenges and, in some cases, opportunities.

Let us not forget the lessons we learnt in 2020 as we face the new year that will bring with it, its own challenges and uncertainties.

Looking to the future

It is incredibly important that investors must consider the risks they can’t see or at least those they haven’t given weight to. Above all else, investors need to carefully consider the valuations they are paying, as we have seen extreme divergences that presents both an opportunity and a risk.

As Warren Buffett once said, “Only when the tide goes out do you discover who has been swimming naked”. We remain confident that our positions are in the best interests of our clients—acknowledging tomorrow’s challenges and working towards a prosperous 2021 with good financial decision making.

Debra Slabber, CFA®

Portfolio Specialist

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

The end of 2020 is just around the corner, and boy what a year it has been. Who would have thought that 2020 would be the year that a pandemic would bring the world to a semi-standstill? We certainly didn’t anticipate that ‘zoom’ would become a buzzword, facemasks would be the latest obligatory fashion accessory, sanitizer would be a must-pack handbag item, and working from home would be the new norm for most.

2020 is most certainly a year that will be remembered and spoken about for years to come. I have heard so many people comparing 2020 to a terrible rollercoaster ride when it comes to markets and emotions. If we had to break up the year (broadly) into three categories, it actually does resemble the motion of a rollercoaster.

Quarter One: The Climb and Collapse

The year started like any other. Shortly into the year, news regarding the outbreak of the Coronavirus in Wuhan started surfacing in the media. At this stage, most shrugged it off, thinking it would be contained and resolved quickly. In hindsight, this was the build-up phase of the rollercoaster, the slightly flat start that quickly elevates – just before the first big dip. In the middle of March, the dip came abruptly, with a deep fall that was filled with fear.

Globally countries went into lockdown, economies were brought to their knees and no one knew how long it would last. Markets sold off aggressively, the oil price collapsed, and South Africa’s sovereign debt was finally downgraded to sub-investment grade (which got a bit lost in all the other bad news at the time).

Quarter Two and Three: The Recovery

The next phase of this year saw the quickest recovery from a crash on record. The S&P 500 took a mere 33 days to recover where it took 517 days to recover from the crash of 2008. The rollercoaster completely tilted in the opposite direction – this time a fast and steep ride up. The largest driver of the quick recovery was arguably the enormous stimulus packages that were introduced by governments across the globe.

Investors quickly regretted not deploying more cash when markets were on its knees. Fund managers called March 2020 the “Covid gift”, a brief time where you had the opportunity to buy fantastic companies at bargain prices. Easier said than done. When humans are filled with fear, they tend to make irrational decisions which end up costing them in the form of investment returns over time.

Quarter Four: Market Jitters and the Rotation

As the second wave of Covid 19 hit countries and lockdown restrictions were imposed in some places again, investors started to fear another crash. Coupled with this was the uncertainty surrounding the US Elections. This phase of the rollercoaster can be compared to when you enter a dark tunnel and you know that something is about to happen, but you are unsure exactly what.

Uncertainty and the inability to see what lies ahead does warrant some jitters. If we have learnt anything, it is that markets hate uncertainty more than anything. But that was not all that happened in the fourth quarter. A possible vaccination is now on the horizon, and the Democrats celebrated victory over the Republicans in the US. Suddenly, the rollercoaster exited the dark tunnel, it was not upside down anymore and the light at the end of the tunnel was in sight.

November marks the month of the “rotation” where “stay-at-home” stocks were exchanged in favour of “out-in-the-world” stocks. The large technology stocks sold off aggressively and that money is finding its way towards the cheaper out-of-favour stocks – tourism shares and financials etc. increased by double-digit numbers in November alone. Despite what conspirators might claim, investors are slowly realising that the world is not about to end, that we will be able to travel, dine out and return to working with our colleagues in offices again.

The big questions now are – how long will this rotation last, is this the end of Covid 19, could a vaccine be distributed across the globe in a timely fashion, and does President Biden have the ability and power to change the direction of the US? Unfortunately, no one knows, and only time will tell.

What is more important, as we reflect on this past year, is to ask ourselves what we could have done differently. Perhaps you made emotional decisions when it came to your investments, perhaps you worried about things that were completely out of your control, perhaps you realised that you should be more diversified.

Wherever you may find yourself in December, take the time to reflect on 2020. What were your biggest lessons, and what would you have done differently?

Someone once said to me “Don’t bet against humanity”, and those words are so true. As people we are resilient, we are adaptable, and we will get through the difficult times.

Debra Slabber, CFA®

Business Development Manager

Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

If this year has taught us anything, it is that we need to hope for the best, but plan for the worst. In financial planning, clients are advised to reassess their financial goals when faced with important life events and/or changes, such as getting married, having a child or with the loss of a loved one. This year, a significant event happened with the outbreak of COVID-19, impacting investors globally. As we approach the end of 2020 and the start of a new year, why not take the time to assess your current financial goals, whether these goals are still relevant, set new goals if needed and make sure you are set-up for success going into 2021.

As clients continue to deal with the stressors and worries caused by the pandemic, they may be having trouble making sound financial decisions. Research has shown that we all suffer from behavioural biases, and we can be even more prone to behavioural mistakes during times of uncertainty.

Uncovering your real goals

It is likely that 2020 has impacted investors livelihoods and financial circumstances, and thereby also their financial goals.

What are your top financial goals? As investors, we all face this question at some point, and we generally have an answer. But have you ever looked at how stable or consistent your answers are, when you think about them in different contexts or at different times? It may surprise you, but researchers have found that we tend to answer with whatever is top of mind, which may not always be our true, long-term goals.

For example, let’s say a friend recently read an article about vacation trips in Italy. When you ask about long-term goals, the response might be: “I’d like to travel more,” even though the person also cares deeply about leaving a legacy of charitable works. It’s not that the person is insincere or that other goals aren’t deeply held – it’s just that is what’s top of mind and easy to recall.

Tailoring your financial plan around your personal goals can both increase your total returns and motivate you to stay on track¹. The success of this technique however depends entirely on having the right goals in place – which research suggests we, as investors, struggle to identify.

To prompt more-thoughtful goal identification, past research suggests that a carefully curated list —a master list — of common objectives can be effective. Master lists have been shown to improve preference identification across a variety of areas. Our research tested the effectiveness of lists for identifying financial goals. We wanted the answer to the question: How can we help investors identify their true financial goals, and not only those that are top of mind?

We found that many people seemed to prioritise goals that were more personalised, detailed, and emotionally grounded after viewing the master list, and the use of a master list also seemed to nudge investors toward more-specific goals.

We found that about half of the people who changed their top goal focused on emotions instead of the outcome. Using a master list drew an important parallel between emotional returns and financial returns. Many people who changed their goals settled on outcomes that revolved around emotional security, such as “to feel secure about my finances now” and “to not be a financial burden to my family as I grow older”. While emotions are often seen as anathema to sound financial decisions, our results suggest that there’s a big emotional component to holistically defining financial goals.

If your goals changed, you’re not alone. At Morningstar, we created a worksheet to guide clients through the process of setting financial goals. Advisors can use this printable exercise to nudge clients toward deeper consideration of what goals are most important to them. This can prompt a meaningful discussion around goal setting and help people avoid top-of-mind, but superficial, goals. We also recommend that you read our research report “Mining for goals” to find out more about the research behind the worksheet.

Behavioural biases, that often creep in during the goal-setting process, surface when we are facing uncertainty — and when it comes to investment decisions, these biases can hurt more than they help. Investors may benefit from having a resource of their own from which to learn the impact of behavioural mistakes on their finances and how to avoid them. We created a checklist you can send to your clients to help them start to incorporate behavioural techniques into their financial decisions.

This checklist is written for investors, so you can offer clients a resource they can peruse on their own time as well as in your virtual check-ins. This way, you can both work together to help clients thoughtfully navigate their financial decisions and empower them to use behavioural techniques on their own when they may need them the most.

Investors are facing quite a few obstacles when it comes to making thoughtful financial decisions. We can’t erase the emotions and biases that come with these unprecedented times, but effective planning and practicing some behavioural techniques can help investors prevent these factors from getting in the way of their long-term financial goals.

This is where advisors can turn to lessons from behavioural science to help keep investors on track. We’ve created a guide and checklist for advisors to explore how to use these behavioural techniques in their practice.

Understanding your financial goals is central to financial planning but identifying goals that truly matter can be tough. Now, more than ever, we must take the time to avoid behavioural biases, establish strong financial goals, and implement behaviours to help meet these goals.

1 – Blanchett 2015; Locke et al. 1990).

Victoria Reuvers

Managing Director

Morningstar Investment Management South Africa

Risk Warnings
This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.
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The expected returns from cash, near cash and income funds will be significantly lower for the foreseeable future.

Retired investors who rely on drawing an income from their investment portfolio, but also need protection against inflation, could be setting themselves up for further disappointment if they are over-exposed to cash-like investments.

Since the beginning of 2016, close to R75 billon has flowed out of multi-asset class funds with low- or medium exposure to equities. That equates to a withdrawal of about 25% of the assets invested in these more conservative balanced funds. And the pace of withdrawal has been accelerating, even during 2019 when these funds delivered good performance.

The Covid-19 lockdown shock added to risk-aversion, causing more investors to reduce the level of risk in their portfolios.

Meanwhile, about R130 billion of net new money was invested in managed income and bond funds over the same four-and-a-half-year period. Another R150 billion was invested even more conservatively in money market and cash plus funds.

The net outcome is that many retirees are more conservatively positioned than is justifiable when applying textbook theory. This is especially concerning given the collapse in cash yields since March this year.

Return gap prompts shift into cash-like investments

So why has there been a such a significant move out of more conservative multi-asset funds?

The shift to cash-like investments is simply an understandable response to disappointing historical performance delivered by these funds. Investors expect to be rewarded for taking on additional risk, with many of the more conservative funds targeting annual returns of inflation plus 3% to 4%. This translates to a return target of around 9% over the past five years. Given the weak state of the local economy, the local equity and property markets performed poorly over the past five years, with annual returns of less than 4% per year and minus 15% per year respectively.

While the more conservative multi-asset funds did better, by on average eking out positive returns of around 5% per year in the recent past, a return gap emerged. These funds also underperformed money market and managed income funds, that on average delivered a little more than 7% per year.

Many investors responded to this gap by switching to managed income and even more conservative cash-like funds.

What investors should remember, however, is that an extended period with no reward for risk is unusual. While managed income funds performed better or the same as the conservative multi-asset funds in three of the past five years, this outcome is not the norm. Looking at the previous five years (2010-2014), the multi-asset funds with larger risk budgets delivered better returns than the income funds in four of the five years. Over this period, these funds returned 10% to 11% per year, more than double the recent experience, while the managed income and cash funds returned a similar 7.2% per year.

Expected returns from cash, income funds to fall

You may rightly think that we can’t plan for the future by looking only in the rear-view-mirror. While we do not know whether the reward for taking additional risk over the next five years will be more like the past five years or the early 2010s, there is one datapoint that there can be no dispute on. This is where we think the biggest risk lies for many retirees, given how conservative their investment portfolios are positioned.

The Covid-19 crisis this year has resulted in a dramatic and unprecedented steepening in the yield curve. Longer-dated government bonds trade at historical highs, with for example the 15-year bond yielding around 11% compared with 9.6% a year ago. At the same time, cash yields have fallen from 6.5% a year ago to 3.5% today.

The net result is that the additional annual yield paid by longer-dated bonds compared with cash has increased to around 7% now from 3% a year ago. While the higher long bond yields are attractive, they are not without risk, as it reflects the market’s concerns about the sustainability of government’s finances. If these concerns were to grow, yields could rise further, resulting in capital losses for existing bondholders.

This argues strongly for the judicious introduction of riskier assets in retirement-funding portfolios.

Avoiding the next possible return disappointment

Our key concern is that the current conservative positioning of many retirees is setting them up for another possible return disappointment over the next five years. Cash yields are at historically low levels and could well remain low for a lengthy period. Long bond yields are high, but that doesn’t come without risk. And local equities are now so unloved that they are undemandingly valued.

We therefore encourage retirees to consider adjusting to the current financial market realities and prudently re-risk their investment exposure. They can do this by investing in a multi-asset class fund that is appropriately risk-conscious.

In so doing, they will be able to gain exposure to the more attractive return prospects available from both international and local asset classes that cannot be accessed through income and cash funds. In our view, these funds are better positioned to take advantage of the investment opportunity set that currently exists than managed income and cash funds.

By Pieter Koekemoer

Pieter Koekemoer is head of personal investments at Coronation./span>

Source: https://www.moneyweb.co.za/mymoney/retirement/retirees-over-exposure-to-cash-like-investments-risks-disappointment/