Safety should come at the right cost

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1907

Guarantees and what to consider

By Francis Marais, Product Director at Morningstar Investment Management SA

Market volatility is one of the few certainties when it comes to markets and investing. During times of market volatility, investors might be tempted to seek out safe-haven assets in an attempt to not only protect their investments against the fall in market prices but also to protect themselves against the emotional turmoil that these periods of market volatility bring about.

Cash is usually the first perceived safety net investors ask about – “should I cash out now and rather get back in when the market is better”; “should I stop investing and just keep what I have in cash for now” or “the rand is so weak, best to sell now”.

From a risk perspective, cash is typically seen as one of the asset classes with the least risk (although not necessarily entirely risk-free) and consequently also tends to offer the lowest return. With this said, cash plays an important role when building a well-diversified portfolio.

We unpack the role of cash in a portfolio in the following article.

For this article, we will turn our focus to another perceived ‘safe-haven’ investment that investors are asking about more frequently, namely guaranteed investments. These products essentially promise (or rather guarantee) a specific outcome and aim to remove the risk of uncertainty. So, naturally, investors ask “why not invest in something that guarantees a certain return?”.

Understandably, investors are seeking more options that could offer some surety or safety amid times of volatility.

Let’s first unpack risk, uncertainty and volatility and how these affect the investments we select

At first glance, it may seem like the distinction between risk and volatility is purely academic. Volatility encompasses the changes in the price of a security, a portfolio, or a market segment both for good and/or bad. So, it’s possible to have an investment with a lot of volatility that, so far, has gone only one way: up. Even more important, volatility usually refers to price fluctuations during a fairly short time — a day, a month, or a year. 

If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb. If you have a short time horizon, are withdrawing an income or need to finance an expense and you’re in a volatile investment, what might be merely volatile for another person is downright risky for you. That’s because there’s a real risk that you could have to sell out and realise a loss when your investment is at a low ebb.

On the flip side, some of the most volatile investments (namely, equities) may not be all that risky for you if they help you reach your long-term financial goals, which typically require returns in excess of inflation. And it’s possible to completely avoid volatile investments but come up short in the end because your safe investments only generated small returns and lost their purchasing power.

Are guaranteed investments safe (and good) options to pursue?

The real questions investors should be asking when considering these investments should include:

  • how much exposure should their portfolio have to cash or guaranteed products?
  • what role will these investments fulfil in their portfolio?
  • what would they be giving up by investing in them, i.e., the opportunity cost?
  • what are their time horizon and long-term investment goals?
  • what else is available that might achieve a similar return?
  • what are the specific costs and liquidity implications?

While the size of the exposure is a personal and more idiosyncratic issue best addressed with the help of one’s financial advisor, we can try and unpack some of the remaining issues below.

How do guaranteed products fit into an investment strategy?

As always, we believe that investors should focus on a holistic portfolio approach that is well-diversified and robust through different market cycles. This approach naturally lends itself to then expose parts of portfolios to different asset classes, time horizons, investment vehicles and products. This not only optimises investment outcomes but also liquidity, tax and investor preferences. In this context, there is certainly a place for cash and guaranteed products considered from a holistic portfolio perspective.

As the name suggests, guaranteed products typically promise (or rather guarantee) a specific outcome. As always, the promise is only as good as the institution making the promise. So, with these types of products, the first order of business must always be to make sure this is with a trusted and well-regulated financial services provider with a strong balance sheet.

A product that provides a guarantee, therefore, tries to reduce both risk and uncertainty by:

  • guaranteeing your original capital investment, or
  • specifying a return per annum (for example 9% p.a.), or
  • specifying a specific payoff profile (monthly annuity incomes until death), or
  • a combination of the above.

Any institution offering to convert risk and uncertainty into lower risk, no risk, and more certainty, essentially offers to take some of this risk or uncertainty onto its own income statement and balance sheet. As compensation, they would be rewarded by generating higher returns and/or revenue. This is done by pooling these risks and unknowns together to form more predictable distributions from which they can make certain assumptions and then by earning either additional returns (you are essentially financing their investment opportunities) or by charging a fee.

The relationship between risk and return fundamentally governs investing and is inescapable. By choosing a guarantee, an investor chooses to lower risk or decrease uncertainty and for this benefit, they must give something in return. This might be in the form of either accepting lower returns (by either giving away some of their returns or paying a fee) or giving up liquidity.

In other instances, a guaranteed-type product can be a very useful tool from a financial planning perspective, such as a guaranteed life annuity. Here you would typically pay a life insurer a lump sum in exchange for a monthly annuity income until death. The more expensive the annuity and the less favourable the prevailing interest rates, the higher the amount of the initial lump sum.

There are quite a couple of varieties around this, but basically, the life insurer hedges any longevity risk (the risk of you outlasting your capital) and you have peace of mind that you will receive a specified monthly income until your death. You could also add an inflationary component, so this type of guarantee could be an effective hedge for some of your more important, fixed non-discretionary monthly expenses. Typically, beneficiaries cannot inherit capital or the initial lump sum used to buy the annuity, so that is an additional “cost” and once again it needs to be weighed against the other benefits and options available.

You could of course also choose to do this yourself, by buying a range of bonds with different maturities to effectively match your monthly expenses. This, however, would require that you have the skill to do this, stomach monthly changes to the underlying values of your bonds and very importantly know exactly when you will eventually pass away. This type of guarantee can therefore make sense within the context of one’s broader post-retirement portfolio – especially in light of behavioural issues such as fluctuating monthly capital values, and skill and longevity risk.

  • There are numerous other examples of guaranteed products, some more useful than others from a holistic product portfolio perspective. An additional point to ponder is what is in it for the party offering the guarantee and why are they offering it now.

For products that offer a multiple of the potential upside that is uncapped, perhaps it’s because the expected upside is small, offering them cheap capital at your expense, with very limited risk on their side to provide a leveraged upside.

As with cash, you should consider what you are trying to achieve in terms of your financial plan, what are you giving up, what else is available that might achieve a similar return and what are the specific costs and liquidity implications. It is also recommended that these questions are considered with the help and guidance of your financial planner. Remember if the guaranteed products weren’t part of your holistic long-term financial plan, then considering them now just because of current market volatility and stress is perhaps not the right time.

In conclusion

An important question to consider is whether what you are paying or giving up is worthwhile and if the same outcomes cannot be achieved by a lower risk-profiled portfolio or better diversification (to name but a few). In many instances, similar outcomes can be achieved by conventional portfolio solutions such as lower-risk, multi-asset solutions that are well diversified, but less expensive and that still offer good access to capital.

Focusing on our response to short-term losses could inappropriately confuse risk and volatility. Understanding the difference between the two—and focusing on the former and not the latter—is key to making sure you reach your financial goals. Do you want to dash to cash or purchase a guarantee because it will aid your investment goal or because you are frightened by market volatility?

By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. It also helps to articulate your real risks: your financial goals and the possibility of falling short of them.