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Investment Strategy
Friday, August 1, 2008
Erosive force?

The South African market has recently seen the launch of a number of structured investment products that offer various performance or capital guarantees. The provision of the guarantee usually requires a lock-in period (five years is typical), during which penalties often exist for early withdrawal. The costs of these guarantees vary from easily quantifiable explicit costs (usually stated as an annual percentage), to the lesser-understood implicit costs.

A common approach to financing these guarantees is through foregoing the dividend stream of the underlying equities. In other words, investors forfeit dividends for the benefit of a capital guarantee.
However, as Matthew de Wet, Head of Investments at Nedgroup Investments, observes, “While there can be no denying the appeal of the guarantees offered on many of these products, it is critical that investors fully understand the mechanism through which these guarantees are funded.
“What many investors may not be aware of is that forgoing dividends is a powerfully erosive force to their total return over time. Furthermore, the likelihood of experiencing a negative return from investing in equities is very low over longer periods of time, and investors may be paying expensive guarantees unnecessarily.”
An investor’s total return from investing in equities is made up of the capital gain component, and the dividend (or income) component. In evaluating the impact of using dividends to finance guarantees in structured products, we examined the total return of the equity market versus the return available if dividends are foregone. The conclusion was clear and consistent: the opportunity costs of forgoing dividends are far too great for investors to ignore.
“We studied the South African equity market history to examine the impact of foregoing dividends. We used monthly data from 1961 to 2006.”
Annual return 1961-2006

As he explains, “It can be seen from the table above that the annualised total return in the South African equity market amounted to 18,9% over the 46-year period. If dividends are excluded, the corresponding annual return over the period reduces to 13,6%. Now, in nominal terms a difference of 5,3% per year may not seem significant. The third column in the table, however, illustrates the remarkable power of compound interest – R100 invested in 1961 would have accumulated to R283 489 in 2006 using total returns, and only R35 479 if dividends were excluded. An investor who did not have the benefit of dividends reinvested would have given up 87% of the potential return over this period.”
  Realistically, not many investors have a 46-year investment horizon. “We, therefore, extended the analysis to examine these differences over shorter periods, which may be of more relevance to the average investor,” explains Mr De Wet.
The graph depicts the impact of forgoing dividend yields over rolling 5, 10 and 20-year periods. What the graph illustrates is that the cost of relinquishing dividends, measured as a percentage of total return, increases significantly over longer and longer periods. This is simply because of the effects of compounding – small differences over short periods, equate to bigger differences over longer periods.
In the above analysis, the opportunity cost of forgoing dividends was 21% over an average 5-year rolling period, 39% over an average 10-year rolling period, and 62% over an average 20-year rolling period. In simple terms, an investor saving for retirement from age 40 to age 60 would have forfeited nearly two-thirds of his retirement savings at age 60, had he not had the benefit of reinvested dividends over the period.

“It is worth mentioning that dividend yields have been in a generally declining trend since the mid-1970s and are currently below their long-term average of 4%-5% per annum since 1960. However, even at an annual rate of 2% to 3% the opportunity costs to investors are considerable and should not be ignored,” he says.
As a final note, what investors will also find interesting is that if one looks at the equity market total returns over monthly intervals of rolling 5-year periods since 1961, not one of the 493 such periods was negative. Investors, therefore, need to be aware that products offering performance guarantees may carry hidden costs, which could end up having a detrimental impact on their benefits at retirement, or upon realisation of the investment. Explicit and implicit costs need to be fully understood, and evaluated relative to the guarantee offered, before making investment decisions.

Copyright © Insurance Times and Investments® Vol:21.7 1st August, 2008
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