Leaving a sizeable portion of your assets in interest-bearing funds leaves you vulnerable to three forces of wealth destruction: low returns, inflation, and tax.
The headline to this article may be a bit dramatic, but this analogy is a good one to point out the dangers of holding assets in safe, but low-yielding assets.
Money market funds have become the default choice for many South African investors fearing the volatility of domestic and international markets. Prior to the 2021 anomaly caused by Absa closing the country’s largest money market fund, inflows into interest-bearing portfolios outpaced equity investments for four straight years.
While this may seem like a wise decision in times of turbulence and uncertainty, I would like to demonstrate why this is a fallacy.
For a start, although domestic money market portfolios have been outperforming domestic equities over one and five years to the end of September 2020, portfolios with equity exposure outperformed over ten and more years.
And if you are serious about growing your wealth, this is the minimum timeframe you should be considering. More importantly, long-term exposure to equities will ensure that investors evade the three apocalyptic horsemen: interest earned, inflation and marginal tax rate.
A conservative investor who has been attracted to the relative safety of money market funds over the last number of years, runs a successful business, and managed to save enough to cover most eventualities.
For the sake of this example, the investor has R5 million cash in a personal bank account, and another R5 million in a business bank account. If this can be left untouched for the next five years, here is how the three horsemen would impact the capital.
Horseman 1: Interest earned
One of the accepted trade-offs of placing money in a safe destination like a money market fund is that returns will be lower over the long term.
While the safety of the deposit is reassuring, the amount earned has to be seen in the context of inflation, widely flagged as one of the biggest risks facing investors in 2022. Only if the investment delivers returns in excess of the prevailing inflation rate, the first horseman is going to weaken the buying power of the investment over time. Consider this, for instance – currently, the larger banks offer interest rates of around 4.2% for investments of a minimum deposit of R100 000 in a money market accounts that allows for access to the funds at any time. Fixed term investments for longer periods typically offer higher interest rates, but most match inflation at best or deliver a small percentage above inflation.
The only way to escape this first horseman is to invest in higher-return assets like equities. Considering the challenges facing the local economy and the resultant impact this will have on the local market, it makes the most sense for South African investors to consider offshore equities that offer higher growth, and a hedge against a weakening rand.
For instance, the Brenthurst Global Equity Fund delivered a return of 24.36% for the year to end November 2021 and 20.91% (annualised) for three years.
This fund, or a range of other funds focused on offshore markets, typically offer better returns than a money market investment would have delivered over the same period.
Horseman 2: Inflation
The second horseman is one that many investors will be facing in the coming year as rising inflation around the globe reshapes expectations for returns from equities.
And while rising inflation may curb these returns, they will still outstrip interest-bearing assets over the long term.
It’s clear that a money market investment returning 4.2% or 5% after fees is not going to be sufficient if we assume inflation of 4.5% (5.5% in November 2021) for this example.
Horseman 3: Marginal tax rate
The final horseman – capital destruction – is possibly the cruellest and is the starkest evidence of why safe but low-growth money market funds make little sense in the long run.
For the purpose of this example, a marginal tax rate of 45% and a company tax rate of 28% is assumed.
With the lower returns (5% per year) on a personal money market investment, the third horseman wielding 45% tax rate lowers the return to 2.75%. Which leaves 1.75% in the red once the second horseman (inflation) has its bite. Compound this annual loss over five years and the investor will have lost 8.45% of capital in real terms.
Investors wanting to evade the three horsemen, should take a long hard look at their money market funds. The safety and low risk it offers can have dire long-term consequences for portfolios.