Investing for South Africans

We’ve noticed a lot of discussion online and in South Africa regarding novel investing paradigms such as NFTs, DAOs, and the “death of value”. Thematic ETFs are abuzz and, at time of writing, year-to-date, Meta is down 34%, Amazon 26%, Netflix 65%, and both Tesla and Bitcoin 20%. The intention here is not to decry the growth of these novel technologies or to herald the coming of a “Big Tech Crash” à la 2001. Rather, this post serves to remind the reader that there are some alternative strategies that can shelter one from the unpredictability and stress of investing directly in innovation.

One illustration of how volatile innovation investments can be is the rise-and-fall of ARKK Innovation. In 2020, ARKK produced countless headlines as 3 of their innovation ETFs burst into the top 10 performing funds of the year. Their primary fund, called “ARKK Innovation”, returned 153% in 2020, the 5th best fund in that year. For comparison, the S&P 500 returned 18.4% that same year. However, as you can imagine, that’s not the end of the story.

While it’s fun to laugh at the expense of successful hedge funds, this story illustrates an important fact for retail investors. Academically speaking, the majority of actively managed funds under-perform the market, especially after accounting for fees (Fama & French, 2009). While there are exceptions, they are few and far between. Renaissance Technologies' Medallion Fund is regularly cited as one such example; $100 invested in the medallion fund in 1988 would be worth $398.7 million in 2018 (Cornell, 2020). This means the Medallion fund has averaged 66% per year for 30 years, a clear demonstration of investor skill. However, given that the medallion fund is capped at $10 billion and has been closed to outside investment since 2003, we’re probably not getting in. So, what are our alternatives?

An investment compounding at a modest 7% per year will double its value in 10 years. This isn’t even applying any exciting strategies, it purely relies on consistency and patience. That said, if you are looking to apply some investment strategies, their primary focus should probably be on tax efficiency, cost minimisation, and accounting for life’s more general risks instead of picking stocks or timing the market. This post will serve to reinforce the old quote from Burton Malkiel’s A Random Walk Down Wall Street (Malkiel, 2019):

It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored.

What assets should you invest in?

We’re starting with the easy question. For 90% of people, the most sensible investment vehicle is a low-cost, market-cap weighted index fund. The MSCI All Country World Index, the S&P 500, the JSE Top 40, and the FTSE 100 are a few good choices that South Africans can get access to at extremely low prices. You don’t have to take my word for it, Warren Buffet has stated as much in his 2013 letter to shareholders:

The goal of the non-professional should not be to pick winners - neither he nor his ‘helpers’ can do that - but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

This is a strong statement, but even when index investing there are some things to emphasise.

Not all ETFs are good. A subset of ETFs known as “thematic ETFs” could actually be quite disastrous. One illustration of the point is the legalisation of marijuana in parts of the United States, which led to a large number of “weed stocks” being listed on the stock market. These stocks produced impressive returns for a while and were at the centre of an abnormal amount of media attention, and became quite popular as a result. They became so popular that ETFs were created to track them. The problem with this idea is that once such an ETF is minted, you’re probably too late given that the buzz surrounding the performance of those stocks is what led to the creation of the ETF. In general, avoiding thematic ETFs is sensible and your portfolio should likely favour ETFs tracking better diversified, total-market indices (Felix & PWL Capital, 2022).

Asset allocation is another major point that could probably justify an article in itself. Warren Buffett has suggested that a portfolio constituted of 90% S&P 500 and 10% US Government bonds would outperform essentially all asset managers. Other heuristics suggest that your stock allocation, if you’re over 20, should be 120 minus your age, with the rest being in bonds. Really, there is no universally-optimal allocation. As a general rule, a higher stock weighting will make your portfolio more volatile but also increase your returns. As a result, your allocation should reflect your risk tolerance; in other words, your stock allocation can be however low it has to be to keep you invested.

Where should you invest?

South Africans have two good options when it comes to investment accounts. A Retirement annuity is an extremely tax efficient and low risk account for long-term investments with a 25 to 40 year time horizon. Tax Free Savings Accounts are a more medium-term alternative with a 15 to 20 year time horizon. However, before you lock your money away for 15+ years, you need to make sure you have enough for this year.

This is what most advisors refer to as an “emergency savings account”. Before considering more long-term investment options you should have immediate access to a sum of money equal to about 3 to 6 months living expenses. This way, a single emergency won’t result in you ending up at square-one. Some also advise that this money should not be tied to the market. This can be justified, since some emergencies, such as retrenchment, could be tied to market performance. Most importantly, you should be able to access this money in a few days, if not instantaneously.

Retirement Annuity

The soft-cap on yearly contributions for South Africans is 27.5% of your pre-tax salary. You can contribute more, but it will be carried over to the following year for the purpose of deductions. However, the added benefit is that your contributions are tax deductible. For most employed South Africans, this tax deduction manifests as a refundable tax rebate, since your employer is required to deduct your taxes from your salary prior to RA contributions being considered.

To illustrate this in the simplest way possible, we will consider an example of a South African under the age of 65 planning to retire in South Africa. They earn a pre-tax salary of R30,000 per month, or R360,000 a year. This leaves a post-tax salary of approximately R25000. Over the course of the year, they manage to contribute an aggregate of R8,250, or 33% of their post-tax salary, to their RA. This maxed out their RA at R99,000. After filing their tax return, SARS will consider their contributions post-hoc and refund them according to their marginal tax rate, which is 31%. That amounts to a refund of about R30,000.

This tax deduction is what makes RAs so attractive, your minimum “return on investment” is basically your marginal tax rate. What other investment will guarantee you that return this year?

One further restriction on South African RAs is Regulation 28, which – after some changes made in March 2022 – sets a 45% cap on offshore exposure. That is to say, 55% of investments made in your RA will be kept within South Africa. While that is a severe limitation, and likely lower than what most South Africans would prefer, recall that it is unlikely that any investment will outperform the tax deduction within a year anyway.

It is possible, if you’re saving particularly aggressively, to max out your RA and still wish to save more. You could always keep contributing to your RA and have those deductions carry over to the next year; but if you’re confident you can max out your RA next year too, then considering the alternatives could be of benefit. This is especially true since the primary alternative does not have a cap on foreign exposure.

Tax Free Savings Account

South Africans are additionally allowed to contribute up to R36,000 per year and R500,000 over their lifetime to a TFSA. The primary benefit of investing in a TFSA is that your returns are not charged capital gains tax; additionally, investments made in TFSAs do not have to abide by Regulation 28. Some practicalities to remember about TFSAs:

1. The R36,000 yearly cap is linked to the tax year, that is March to February.
2. If you exceed the cap, you are charged a tax-fee of 40% on the excess (so don’t do this).
3. Both the R500,000 and R36,000 apply at the individual level, so all your TFSA accounts are counted together.
4. If you withdraw money from the TFSA, the contribution still counts towards your overall yearly and lifetime cap (so don’t do this either).
5. Dividends do not affect your contribution limit.

Since every contribution to your TFSA reduces your lifetime limit, and withdrawals don’t reverse that reduction; you should consider money placed in a TFSA untouchable. Maxing out your TFSA will require 167 monthly contributions of R3000, or about 14 years. Additionally, since your gains are tax free, it would not be sensible to max out the account and then immediately withdraw the money; ideally it should be allowed some time to accrue that tax free interest. It can be helpful to project the value of what such an investment would be: assuming 7% annual returns, maxing out a TFSA with 167 R3000 monthly contributions, and then allowing that investment to accrue interest for a further 5 years will result in a tax-free ~R1,170,811.96. Your annual return may be higher or lower (although 7% is often considered a very cautious estimate), and this does not include fees, but nonetheless that is a healthy return on the R500,000 contribution.

Conclusion

The flowchart above outlines the personal investment strategy for South Africans proposed by this post. While receiving and understanding it conceptually is quite simple, the difficulty is in finding the conscientiousness and patience to see it through. Especially during market downturns (one of which we are living through now), the temptation to divest your money can be strong. No article can confer the ability to resist that temptation but it can be reassuring to know that your investment strategy is rationally-grounded and sound.

References

Cornell, B. (2020, March). Medallion Fund: The Ultimate Counterexample? The Journal of Portfolio Management, 46(4), 156-159. https://doi.org/10.3905/jpm.2020.1.128

Fama, E., & French, K. (2009). Luck Versus Skill in the Cross Section of Mutual Fund Returns. Journal of Finance, LXV(5), 1915 - 1946. https://mba.tuck.dartmouth.edu/bespeneckbo/default/AFA611-Eckbo%20web%20site/AFA611-S8C-FamaFrench-LuckvSkill-JF10.pdf

Felix, B., & PWL Capital. (2022, May 4). Thematic ETFs (are Terrible Investments). YouTube. https://youtu.be/dwPh-PAg9A8

Malkiel, B. G. (2019). A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing. W.W. Norton.
 
   

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