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Investment Strategy
Sunday, October 1, 2006
Yield pursuit

Yields on fixed income investments are at historically low levels despite the recent 50 basis points hike in interest rates. Conservative investors can, however, enhance their after-tax returns without undue exposure to the risk of further interest rate increases, says Tamas Kulcsar from SP² Advisory Services.

“In a low interest rate environment, cash returns are unattractive and yield-enhancing investments such as income funds are vulnerable to interest rate hikes,” says Mr Kulcsar. “Interest rate increases, which are positive for an income stream would, however, reduce the capital value of an investment.”
Furthermore, he says, cash looks “particularly poor after income tax is taken into account. The average money market fund last year yielded just 4,1% for investors in the top income tax bracket. This is likely to be insufficient for most investors’ income needs.”
Traditional solutions to this conundrum include investing in preference shares or stocks with a high dividend yield, both offering non-taxable dividend income. However, due to the inherently higher risk of share investments, and the current yield of the All Share Index at a low 3%, shares would not be a suitable option for risk averse, conservative investors.
“There are other options available to conservative investors in which they can create a tax efficient portfolio with a high level of income, low volatility and a low correlation to equity markets,” says Mr Kulcsar. “These options include tax efficient unit trusts, which can give an additional 2% yield with no increase in volatility.”
By combining low risk absolute return unit trusts, dividend-income funds and flexible fixed interest funds one can construct a portfolio that meets the above criteria, he notes. The absolute return funds – specifically the Investec Absolute Balanced, Nedbank Inflation Beater, Allan Gray Optimal and RMB Absolute Focus funds – use differing strategies to generate total returns (income plus capital growth) that exceed an inflation benchmark.
“These funds extensively use derivative instruments – stock market options and futures – to generate low volatility returns, predominantly in the form of dividends and capital gains,” he says.
The dividend-income funds – offered by Absa, Sanlam, Stanlib and Prudential – use special purpose vehicles to “convert” interest payments into dividend-based distributions. Dividends are currently not taxable and capital gains are taxed at a low effective tax rate of 10% for natural persons.
According to Mr Kulcsar, returns generated by tax-efficient funds have historically fallen between those of money market funds and income funds before tax, with 12-month rolling returns of 7,5% to 10%. The dividend nature of returns reduces the effective tax rate from a maximum rate of 40% for money market funds to 14%.
“This equates to a tax saving of approximately R20 000 on an investment of R1m – or 2% of total returns. This is significant considering that an average income fund’s returns have been around 10% per annum.”

Copyright © Insurance Times and Investments® Vol:19.5 1st October, 2006
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