SA’s riskiest investments

by Alex Funk, head of asset consulting, GCI Asset Management 13 views0

SA rand plunges to record low Nigeria's central bank’s credibility again took a massive hit on JP Morgan's decision:

1.     What are the riskiest investments available in SA at the moment?

When one defines risky versus safe investments, there are many factors to consider. Traditionally it is accepted that stocks are more risky investments than bonds and cash instruments. Although the true fact may be that they may both be risky or safe investments. Take for instance if you had invested in a bond portfolio that was heavily exposed to African Bank in 2014. Your Bond portfolio would have provided negative returns during the last two quarters of last year, while a share portfolio would have provided you with positive returns. If a client or individual defines risk as the probability of losing capital, then a different methodology has to be applied in order to protect clients from risk. By combining a variety of asset classes from various geographic regions a client can diversify their portfolio extensively enough to minimise the probability of loss. The most common process to achieve this outcome is to use a Multi-Managed approach. This process combines lowly correlated assets with one another to provide a portfolio that is protected from extreme volatility. E.g. if Asset Class A( Stocks) decreases for any given reason, there is a high probability that another Asset Class, Asset Class B ( Gold Commodity) will increase, this is because the assets are lowly correlated and don’t behave in the same way. This is the best form of protection for an investor in the current uncertainty of the financial markets.

 2.     By contrast, what are the safest investment options?

In theory, the safest investment in the market is a traditional Money Market investment. This fund is usually backed by cash like instruments of a very high quality. The credit rating of the underlying bond issuers are above junk status and the investor is more than likely protected from bond issuers defaulting. But investing in a money market investment is currently the poorest decision an individual can make. Inflation figures have tamed down in 2014 to a low of 5.8% in November, this is still considered high as the actual inflation of food, medical costs and clothing is much higher, at Inflation +2/3%. Hence if you invest in a Money Market instrument your returns are likely to be in the region of 5%; you are therefore losing money year-on-year as inflation is eroding your capital. It is a far wiser decision to invest in a balanced multi-managed strategy with a longer time period in order to beat inflation and ensure you reach a safe and secure retirement.

3.     What questions should you ask yourself before engaging in risky investments?

This analysis should be completed by an experienced wealth manager because there are so many factors to consider. But here are the basics that need to be understood before undertaking any investment decision:

  1. What is your return objective? You need to analyse the purpose of the investment and match that with a return objective that will deliver the required result. This is known as Asset Liability Matching. The liability is the purpose of the investment and the asset is the investment made to meet that liability.
  2. What is the term you are going to be invested for? This is crucially important; consider how long you will invest and how long is required to match your liability as defined above. For instance you are saving money today for your child’s varsity education in 18 years. This is a longer investment period and you can invest in assets that are more risky to deliver higher returns.
  3. What is your liquidity requirement on the investment? This refers to how soon you may need to liquidate your holiday. Is this investment for emergencies? If you have a medical emergency, will you need to cash in the whole investment? Analyse the instruments you invest in; for instance certain hedge funds or smaller stocks may have limited liquidity and may only be liquidated in a months’ time.
  4. What is your overall dependence on the investment being made? For instance if this investment represents your entire pension fund, you may have to scale down the risk in the portfolio because you cannot afford volatility and ultimately a loss in capital. If this is a speculative investment and you are not dependent to live off the investment, you can afford to take more risk. This is a very difficult analysis and needs to be considered with extra care and attention.

All these factors have many more layers and complexities; it is crucially important to discuss these issues with a qualified Wealth manager.

 4.     Briefly explain the difference between death-knell and penny stocks.

A Death-Knell stock is a stock that is traded on a stock exchange, the stock is representative of a company near bankruptcy and in a poor financial state. This is considered to be a high risk investment as the company may actually become bankrupt and liquidate all holdings resulting in the investor losing all their money. The upside is that the stock can be bought at a very low price (due to its poor financial status) and should the company recover and earn profit again in the future, the investor would make large returns on a very low cost investment. A Penny Stock is a share of a company with a very low market capitalisation (Small Company), these stocks are generally not traded on a formal exchange and are a speculative buy. The investor is able to buy the stock at a low cost due to lack of liquidity and because the stock is analysed regularly by asset managers and analysts alike; there may be inherent price discovery available. It would be like discovering a hidden gem; purchasing a share in Apple before they formally listed and became the large organisation they are today.

 5.     What are derivatives or stock options and what makes them so risky?

Derivatives are instruments used to hedge portfolio risk; it is a form of buying security or protection. They may also be used to enhance returns or take speculative bets on specific positions that fund managers have large convictions on. The two broad categories of derivatives used are options and futures. There are many more and very enhanced strategies used alongside derivative instruments, but for the purpose of this article I will briefly  delve into futures and options only. A future allows an investor to purchase an asset at a given price at a pre-determined point in the future; the investor does not have the option to buy the asset and is therefore obliged to purchase at that price. A future contract is entered into today at no cost. An option provides the investor the option to purchase a security at a given price (called the strike price) at a given point in time, the investor is not obliged to purchase the security at this point and may forgo the option. For this luxury to decide whether an option will be executed or not, the investor pays an option premium. An investor may purchase an option or a future on the short or the long side. The long side provides the investor with the ability to purchase a security and the short side providing an investor to sell a security. Options and futures are considered to be risky assets if used with a well-constructed hedge strategy. For example, if you decide to buy a long future on a stock today at R20 per share and the share price actually declines in the future, your contract obliges you to buy that stock at R20. The share price may have fallen to R1; locking in a R19 loss for the investor. With options, you have the right to abandon the purchase, but this comes at a cost of the option premium. If you abandon the option, you forego the option premium and lock in a loss of the premium or even worse the opportunity cost of investing the option premium elsewhere and earning a return on the money.

6. Are hedge funds a risky investment?

Hedge Funds are pools of money that are combined to invest in a mutual fund style. Hedge funds are not regulated and hence have more flexibility to invest in a wide array of asset classes. Some asset classes may be illiquid, carry significant risk ( investing in companies with a turnaround strategy) and making extensive use of derivatives and leverage. This makes hedge funds a risky investment for the individual investor and should be invested with great caution. Leverage in Hedge Funds refer to borrowing money from an institution and using the borrowed money to invest in an asset. The risk here is that the fund manager or investor first needs to clear the cost of debt before any profit is made. Example, XYZ Hedge Fund has borrowed R1m to invest in a newly founded tech company; the company has good prospects but requires large amounts of capital to start production of their new projects. The company issues shares to raise capital. The hedge fund purchases R1m worth of these shares as an investment. During the next year the company’s projects all fail and is forced to shut down. This means the hedge fund has lost its initial investment, R1m and is still obligated to repay all the debt it accumulated. There are many strategies that hedge funds could undertake and some are more risky than others, but investors should consult with experienced Wealth managers who understand all the underlying instruments before pursuing such an investment.

 7.     Any other risky investments e.g. commodities?

There are a range of other investment vehicles that can be considered risky investments, such as Direct Property Investments, Private Equity Funds, Venture Capital Funds and Commodities. These investment vehicles are largely considered to be risky due to the fact that they are highly illiquid. This results in the investors’ money possibly being tied up in investments for a long period that is loss leading.