Generally, equity is expected to perform significantly better than cash but over the last five years, SA cash has outperformed SA equities. “This begs the question: ‘is cash a better investment option in South Africa right now?’” says David Crosoer, Executive: Research & Investments at PPS Investments.
The CPI+2% per annum return clients received from SA cash over the past five years is consistent with PPS Investments’ long-term expectation for this asset class. It is unlikely that the return from SA cash will deviate from this, unless there are exceptional circumstances or a change in the mandate of the South African Reserve Bank (SARB).
As an example, SA cash gave a return less than CPI+2% per annum in the five years following the global financial crisis, where interest rates were deliberately kept low by most central banks. “We would expect it to be threatened should the independence of the SARB be compromised. Other deviations are likely be temporary, given the SARB would adjust short-term interest rates to unexpectedly low – or high – for inflation.
In contrast, Crosoer explains, the CPI+1% per annum return from SA equities over the past five years has been substantially less than the long-term expectation for this asset class. “Unlike with SA cash, however, we expect considerable variability around this long-term expectation, given the volatile nature of this asset class, and therefore this return is also not entirely unexpected.”
There is considerable empirical support that the equity-risk premium (i.e. the additional return equities should give over cash or bonds) should be at least 4% per annum, but also that this relationship need not hold for any given period. This has certainly been the case over the past five years where SA cash has outperformed SA equities!
“Our investment process strives to deliver consistent outcomes for our clients. It aims to deliver on this by diversifying risks where possible, and only taking on as much risk as we believe is necessary to achieve our objectives,” says Crosoer. However, he does not believe that the current situation should lead to a focus of SA cash over SA equities.
“In any given period, equities could woefully underperform SA cash but if the return requirement is more than cash can deliver, holding cash will guarantee that it will fall short of its objective.”
The starting point for PPS Investments is establishing whether the return objective requires taking on equity market risk, and then incrementally increasing the equity market exposure for every additional level of required return. “Our investment process presupposes that equities need to be held to achieve any return objective greater than CPI+2%. Here the risk of not investing in equities is that the return expected from the other asset classes might be insufficient to deliver on the overall return targets.”
For every 1% additional return, an additional 22.5% equity market risk needs to be taken on. In other words, we expect equities to outperform cash and bonds by approximately 4.5% per annum. This is demonstrated as follows:
“Importantly, at CPI+2% per annum, our process suggests we don’t need to take on any equity market risk. Here our process would try to mitigate other risks including the reinvestment risk from cash by holding longer-dated bonds,” says Crosoer.
“It must be remembered that the performance of SA equities over the past five years is not unusual, and there will be more periods where SA equities underperforms SA cash. The poor performance of SA equities meant that all portfolios with some exposure was likely to have fallen short of its return objectives.”
This does not, however, mean investors would be better off investing in cash. “Investing in cash is more than likely to cap the potential upside to expected real returns to no more than 2% per annum.”
“Investors that require returns greater than what cash can realistically deliver do need to take on equity market risk. Our investment process is deliberately designed to give only as much exposure to equity markets as necessary, given the return objectives, and help mitigate against underperformance in periods where equity markets do not deliver,” ends Crosoer.