The fees and the tax you pay on your investment are usually calculated as a percentage of your returns. So, in the current environment of low inflation and low returns, high fees and tax will erode a greater portion of your returns.
In the current low-inflation environment, you should make sure that costs do not erode a larger portion of the returns you earn on your investments before taking inflation into account, Matthew de Wet, the investment manager at Nedcor Retail Investments, says. And when you weigh up investment returns, you should mostly concern yourself with the after-inflation, or real, returns, he says.
Investment fees are of critical importance in a low-inflation environment, because you usually pay fees based on a percentage of your investment, De Wet says.
When inflation is low, the nominal returns (in other words, the total return without subtracting the amount you need to earn to keep up with inflation) are lower, and the fees will erode a larger percentage of that return, he says.
Fees eat up returns
De Wet says the impact of fees is particularly important for people who live on an income generated by cash investments, because, as their nominal returns drop in line with inflation, the fees consume an increasing portion of their nominal cash flow.
For example, he says, assume two investments produce the same real return of seven percent. Your real return is the return after taking out the amount you need to earn for your investment to keep up with inflation.
In the first investment (Investment A in Table 1), the inflation rate is three percent, and in the other (Investment B), the inflation rate is 13 percent. This means that the nominal return on Investment A is 10 percent, while the nominal return on Investment B is 20 percent.
If, in both cases, the costs are two percent, the fees as a percentage of your nominal return in Investment A are 20 percent (two percent of 10 percent), while in Investment B, the fees as a percentage of your nominal return are 10 percent (two percent out of 20 percent).
The real return in both cases is the same, so your real return after fees is also the same with these two investments. But remember that higher fees will always have a greater effect on the performance of your investment than lower fees.
De Wet says South Africa's inflation rate is currently low and stable - this is the first period in which it has been low and stable since the 1960s.
The average inflation rate between 1970 and 1999 was 11.4 percent a year, he says. But since 2000, inflation has averaged at below five percent a year (well within the South African Reserve Bank's targeted range of three to six percent), he says.
In this lower and more stable inflation environment, De Wet says, investors need to differentiate between nominal and real (after-inflation) returns.
Investors should concern themselves with real returns, because these returns determine whether or not you are increasing your spending power, he says.
You should remember that in a low-inflation environment, nominal returns may be low, but your real returns may still be healthy.
De Wet says since interest rates started falling in 1999, real returns from equities and bonds have been in the region of 15 percent a year and those from listed property 20 percent a year. These returns are much higher than the long-term average real returns for equities (seven percent a year over more than 100 years), property (4.5 percent a year over the past 20 years) and bonds (two percent a year over more than 100 years).
An environment of low and stable inflation is generally good for economic growth, De Wet says, because it usually means lower and more stable interest rates, which stimulate investment by both corporates and individuals. The prices of shares and bonds and other assets also tend to be less volatile when inflation is low and stable, he says.
However, investors who rely on cash investments for an income may be at a disadvantage.
Although their long-term average real returns have remained at about one percent over the past six years, the interest earned on cash has fallen from 15 percent to seven percent, more than halving the monthly nominal income of investors who rely purely on cash deposits, De Wet says.
Cash investors need to diversify their portfolios in order to earn higher real returns which will grow their capital while they draw an income. Only investors with extremely short investment time horizons should be invested exclusively in cash, he says.
Tax factor
De Wet says investors should also aim to maximise the investment returns they earn after tax.
A low-inflation environment is beneficial to investors from a tax perspective, because your tax liability is calculated on your nominal returns rather than on your real returns, he says. Using the same example as in Table 1 and assuming you are earning income on an investment that is taxed at the highest marginal tax rate of 40 percent, the tax you pay as a percentage of your real return will be higher when your nominal returns are higher (see Table 2).
Taxation is also a key driver of net returns, De Wet says. Traditionally, too little emphasis has been placed on the tax status of investors and most products have been designed to maximise pre-tax returns. This is clearly not economically sensible, he says.
Where appropriate, you should try to maximise your investment returns on an after-tax basis, De Wet says.