11 months ago

Blue Chip Issue 82

  • Text
  • Financial
  • Advisors
  • Investments
  • Equity
  • Wealth
  • Offshore
  • Asset
  • Portfolio
  • Investing
  • Global
  • Momentum
Welcome to our Investing Offshore Special Edition of Blue Chip. a quarterly journal for the financial planning industry and the official publication of the Financial Planning Institute of Southern Africa NPC (FPI). Blue Chip publishes contributions from FPI and other leading industry figures, covering all aspects of the financial planning industry.


EQUITIES INTERNATIONAL INVESTING The importance of the Equity Risk Premium Thoughts, Discover, Idea, Creation and Success. These were some of my options as I stared at an expansive menu. It was a cold December morning and I was standing in a Trung Nguyen coffee shop, a large Vietnamese chain, on my first day in Hanoi. Anthony Bourdain’s books are my go-to food guides when I travel. He wrote that Trung Nguyen was part of his daily routine whenever he was in Vietnam, so I had to get my first coffee here. Eventually I picked a milky drink that fell somewhere on the cappuccino-latte-macchiato continuum. It was pretty good. I didn’t realise that I missed the reason I went there. No, it wasn’t for a cup of Success either. My next coffee stop was at a rustic Trung Nguyen store. They only served traditional Vietnamese drip coffee. There were only two decisions to make. Hot or over ice and sweetened with condensed milk or not. It’s brewed in front of you from a metal canister, containing ground coffee and hot water, slowly dripping a golden-brown elixir into a glass below. It was delicious, simple and cheap. That was the only coffee I drank for the next two weeks, and it freed me from the anxiety of too much choice. This was the coffee that an insightful, well-travelled chef and food writer went back for every day. I had the right expert advice but ignored it when confronted with a menu that was too wide for me to understand. Too much choice is a burden. Investors often face a similar issue. The idea of near limitless investment options is alluring but can distract and misdirect from a carefully designed plan. Financial advisors may inadvertently overwhelm clients when they offer them more choices than they can process, some of which they may not even understand. A small number of relevant choices is more useful than an exhaustive list. Advisors can further help clients by providing them with a rules-based decision-making framework to select between the available options. A good starting point for a rules-based approach is to use broad market exposure as the default position. The risk-return tradeoff and costs of all other alternatives can then be compared to this. This simplifies decision-making and, like the Vietnamese drip coffee, simpler does not mean worse. Simpler might be what your client’s portfolio needs. Consistent long-term exposure to the broad equity market has been a winning strategy. It incorporates the collective insights of all market participants and has rewarded investors with real returns that have been hard to beat. It has overcome wars, pandemics, inflation and financial crises. It’s been a powerful force that investors have relied upon for more than a century. The Equity Risk Premium (ERP) is a way of quantifying this force. The ERP measures the historic out-performance of the equity market relative to risk-free investments – usually short-term government bonds. It is a useful measure because it provides insights into the long-term equity market performance in relation to an alternative investment. The ERP is usually measured over multiple decades and is often interpreted as the long-term reward for accepting short-term equity risk. 22

EQUITIES Given enough time, a consistent drip of returns accumulates into a surprisingly large reward. The long time frame means that it can be used to estimate the range of future returns that can reasonably be expected. This helps to calibrate an investment plan using realistic assumptions. It also provides a framework to assess the expected risk-return tradeoff and higher fees of active management strategies. The MSCI World Index, a developed market large and mid-cap index, returned 9.2% p.a. in US dollar terms from the time it was first calculated in 1970 to November 2021. US inflation averaged 4% p.a. over the same period which means that the real return was 5.2% p.a. The ERP was approximately 4% p.a. over this time. Given enough time, a consistent drip of returns accumulates into a surprisingly large reward. The flow of returns isn’t always smooth, and there is always the risk of a crash or a crisis. The three largest drawdowns occurred during the 2008 Financial Crisis, the Tech Bubble bursting in 2002/03 and the Oil Crisis of 1974. The market typically recovered from these in four years but clawed back most of its losses in less than two years. These were painful to live through but over a long enough time frame, the portfolio always recovers and rewards patience. Exposure to the ERP doesn’t mean investing in an index tracker. Market exposure can come in different flavours and it’s important to pick the approach that best suits an investment plan. There are however a few important things to keep in mind. The risk premium has averaged 4% p.a. which compounds to a big real return over time. This is relatively easy to capture but can be quickly eroded by high costs and unintended risks. High fees and opaque transaction costs can rapidly whittle away performance. A portfolio should also be well diversified with representation across countries and industries. Diversification adds resilience and mitigates against large losses. Finally, the portfolio must be fully invested at all times. A large proportion of market returns come from a surprisingly small number of days. These are impossible to forecast which makes market timing an especially risky undertaking. Financial advisors play an important role in guiding clients and should ensure that they have the tools to make informed choices. This includes educating clients about the power of investing in the broad equity market which has been the safest path to inflation-beating returns. Using this as a starting point can simplify decision-making, lower costs, reduce unintended risks and help to implement an investment plan with fewer distractions. Reza Khan, CEO, Lodestar Fund Managers 23

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