In this episode, Warren Ingram and Kelin Pottier, Solutions Strategist at 10X Investments, discuss the different ways to store cash in unit trust funds. They explore the concept of income funds, which aim to deliver a high level of income while maintaining capital stability, the risks involved in income funds and the importance of regulations and diversification in managing these risks.
Takeaways
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Have a question for Warren? Don't forget to voice note your questions through our WhatsApp chat on (+27)79 807 8162 and you could be featured in one of our episodes. Follow us on Twitter, LinkedIn and subscribe to our YouTube channel for more Financial Freedom content: @HonestMoneyPod
In this episode, Warren Ingram and Kelin Pottier, Solutions Strategist at 10X Investments, discuss the different ways to store cash in unit trust funds. They explore the concept of income funds, which aim to deliver a high level of income while maintaining capital stability, the risks involved in income funds and the importance of regulations and diversification in managing these risks.
Takeaways
For more valuable insights from the 10x team, click here.
Have a question for Warren? Don't forget to voice note your questions through our WhatsApp chat on (+27)79 807 8162 and you could be featured in one of our episodes. Follow us on Twitter, LinkedIn and subscribe to our YouTube channel for more Financial Freedom content: @HonestMoneyPod
The Honest Money podcast is powered by 10X Investments, a licensed financial services provider. Consult with your financial advisor and let's 10X your future together.
Speaker 2:Welcome to Honest Money. We're talking about one of the most popular forms of investments today, which is storing cash in funds, in unit trust funds, and it's not as simple as it sounds, because, like everything in the investment world, there isn't only one way to store cash. There are a few different ways to store cash, and it's certainly not my area of expertise. So I'm very glad to have brought in some heavyweight backup, and so we've got Kellen Potier. He's the solution strategist at 10X. Kellen, thanks so much for joining us on the show.
Speaker 3:Hi Warren.
Speaker 2:Thanks, Ken, for having me on the show for our listeners typically, I think, in the Unitrust world. I think it's a great place actually to store cash. Firstly because it's fairly safe but we'll get into that detail now but just they're generally two ways. So there is a money market Unitrust, which a lot of the time people think you can only get at a bank, which is not true. You can get them from a lot of fund managers as well. And then you get a category of unit trusts called income funds and for me, generally a place that I prefer to store cash than a money market fund. But I think we need to just kind of give an explanation to kick off. What is an income fund?
Speaker 3:Well, I think, like you said, the starting point for most investors who've got extra cash that they want to invest but they don't want to take any risk with would be to look to a money market fund where they're going to get probably a slightly higher interest rate than they would if they placed their money on call with the bank, but not necessarily an exceptionally high rate.
Speaker 3:So, for investors looking for a higher return than a money market fund is where you would venture into income funds, and these are funds where the investment objective is to deliver a high level of income whilst maintaining capital stability and really having a strong bias towards capital protection. So very, very similar in terms of very stable interest rates, driven returns, but without taking on excessive risk. And I would just say that there's two categories of income funds. I think the one that most people are familiar with is what we would refer to in the industry as an enhanced cash fund, which is just aiming to give you a higher return than money market maybe an extra 1% higher than money market and then you've got real return income funds, which are funds designed to deliver a return exceeding the rate of inflation typically inflation plus 2% to 3.5%. So they're slightly different in the risk profile, but all aiming to deliver a high level of income with stable return of capital.
Speaker 2:Okay, so let's just explain that for one second.
Speaker 3:So enhanced income is reasonably low risk relative to then the high income funds. Yes, yeah, that's exactly it.
Speaker 2:So one would have no fluctuations from month to month, whereas those that have a real return outcome you may see some fluctuations from day to day and month to month, but not about stability and protection. So I think, just to explain that a little bit, there is no capital guarantee with an enhanced income fund and you know, the idea would be that you might see risk in the way that the interest is a bit lower than you thought it might be. But there are going to be very few sets of circumstances where you actually you know you put in 100,000 and a year later you've got 98,000. It's more likely that if something went wrong, you put in 100,000, you've only got 101 and not 108, just as an example. Yes, yeah, I as an example.
Speaker 3:Yes, yeah, I think that's exactly right. It's not to say that it's impossible to lose money in a money market fund. You certainly can't, Sorry in an income fund. You certainly can lose money in an income fund, but it would be from very specific risks, not just from general market volatility, sort of ups and downs as you would see in the stock market.
Speaker 2:So I think that's a nice step to then let's just talk about those risks a little bit. It wasn't long ago that we saw, you know, a fairly sizable income fund, you know, taking a big knock where they had to take a portion of their money and put it in I mean, I love the phrase in a side pocket, you know, as if you know, we've got lots of pockets for our money and the basics there and it's my words, not yours is these guys made a mistake. They were managing money. They were generating very high rates of interest for their investors. Investors were enjoying the ride and forgetting that one very basic principle in the world of investing when you get very high returns, there must be something to pay, and the pay is risk.
Speaker 2:And they were taking risk and the risk came back to bite them. Back to bite them and all of a sudden they're sitting with what they thought were low risk investments that are now taking a serious capital knock and that money's been set aside and the balance of the money is able to be accessed at any time the set aside money. Unfortunately, if you're an investor in that income fund, you can't touch your money until that fund manager decides you can. They're going to tell you it's about stability and protection, all of those things, but the reality is someone else is now deciding when you can access your cash, and that's a disaster. No matter what, that's a bad outcome. But that would be one risk would be the fund manager making bad decisions on what instruments to buy. Are there any other risks that we would see in an enhanced income fund?
Speaker 3:Yeah. So, at a basic level, every investment you could possibly make is all exposed to one common risk, which is inflation risk, the risk that your money doesn't grow as fast as inflation. So that is the number one risk that is in every investment right. You wouldn't invest if you couldn't beat inflation, otherwise you'd be going backwards in spending power terms. So this becomes even more important when you are investing for income and particularly when you're investing in cash. We know cash struggles to keep up with inflation over the long term, and so your starting point is then say how can I deliver a higher return than cash, that I can actually start beating inflation? And then, as you've said, to get a higher return you need to bear somewhat more risk. So the two risks that you sort of take on in an income fund to generate that higher return are interest rate risk and credit risk. So interest rate risk is to say that fixed income instruments, so bonds, are fixed rate instruments where you have a fixed coupon payment that you get in exchange for loaning the company or the government money. The value of that bond moves in the opposite direction to the interest rate or the yield. So if interest rates go up and yields move up with it, you would experience a capital loss. On that. The reason is quite simple. If you had locked in an interest rate of X and the other available interest rates in the market are all of a sudden higher than that, for that bond to be able to trade it needs to be able to lower price to generate an equivalent interest rate to make it comparable with other bonds. So that's your first risk is interest rate risk. So high interest rates can look really good up front, but you obviously take on the risk that you know there could be higher interest rates in the future, which is sort of an opportunity cost for locking in that fixed rate, and that's where that risk comes from. And then the second risk that's born in income funds is credit risk. So when you are making a loan, either to a government or to a company, there's a risk that they don't pay you back your money. Either they don't make back an interest payment or they don't pay you back the full principle of your loan at the end. And so in order to accept these risks, as an investment manager you need to consider are you being adequately compensated for bearing these risks? And so it's by taking on these risks that one is able to generate a higher return than an income fund.
Speaker 3:Now, if you just think of how does an income fund manager achieve this? You invest in a host of different instruments. You invest in cash and money market instruments as a starting point. That gives you a base level of return on cash. Cash and money market instruments as a starting point. That gives you a base level of return on cash. But you know you're bearing inflation risk, but there's no credit risk. Your cash deposits are effectively guaranteed.
Speaker 3:Then you have your fixed rate bonds, which is either to governments, where you're going to take on this interest rate risk and you should get a higher return, and you don't have any credit risk because the government can always pay you back. Why Government can raise taxes, it can print money and make sure that you are a whole, but you still bear inflation risk because that fixed rate might not be in the same place that inflation is a few years from now. But then you've got floating rate bonds. So these are investments that you make when you loan money to a corporate company. Here because you don't want to take on too many sets of risk. You only want to expose the credit risk.
Speaker 3:These instruments would typically have an interest rate that varies. So as interest rates go up in the market, the interest rates paid by the borrowers would also go up. So here you're able to isolate out the interest rate risk, but you do bear the credit risk, the risk of default. And then your last sort of category is inflation-linked bonds to the government. Here you've isolated out the credit risk because the government will pay you back. You've isolated out inflation risk, but you bear more interest rate risk because these are more sensitive instruments. Now the role of an investment manager is to say how do I best blend each of these different instruments so that I don't have extreme exposure to any one particular risk and that I can be diversified across a number of different companies, different issuers, different instruments, that I can generate a stable return profile with higher rates of return than I would get relative to inflation and relative to a cash alternative.
Speaker 2:And that's really the role of an income fund manager. So I think that and this is where one of the kind of real safety nets of the unit trust industry kicks in because it's not entirely up to that fund manager to decide what proportion of the money gets invested in cash, what proportion gets invested in the floating rates, the regulations around unit trusts, what proportion gets invested in the floating rates, the regulations around you know trusts dictate what proportion you can. So just for argument's sake, if it's an enhanced income fund, they can't suddenly decide on their own because they work up on Monday feeling you know that the world is in a great place to then allocate all of your money to the riskiest part of the interest rate market, the floating rate bonds. The regulations will say you're allowed to allocate X percent to that and you must allocate a portion to government bonds. So you get a form of interest rate and credit risk diversification simply because of the regulations.
Speaker 3:Yeah, so investors are really well protected by the regulations in the industry, as you've mentioned, and I think this is where it becomes particularly important. One is that you have this protection, but it is also your role as an investor when selecting an income fund to pay careful attention to how the portfolio is constructed. You know, pull up the fact sheet or the minimum disclosure document from the investment manager. Take a look at what that portfolio is invested in. Does it seem to have a lot of credit risk? You'll see a lot of exposure to floating rate notes. Does it have a lot of interest rate risk? Do you see too much exposure to government bonds? Does it have too much cash? It can be left behind by inflation.
Speaker 3:So you know it's important the investment manager is doing this assessment on your behalf. But you need to now choose sort of the best investment manager. So you know, really look for those investment managers who do have a sort of good track record of managing these risks but also are very prudent and seek to diversify their portfolios away from any one particular issuer, company or instrument. And that really goes a long way, because in an asset class like fixed income, it's not like investing in stocks where your money could go to the moon. If the company is just amazing right, it saves the world In income investing. The best case scenario is you get back your money, the worst case scenario is you lose it. So the upside versus the downside is quite asymmetric, and so this is why more conservative managers who really pay careful attention to the risks they're taking and how they diversify and manage those risks accordingly is crucial.
Speaker 2:And I'm not going to put words in your mouth and I and I'm not going to put words in your mouth. So this is the honest money take on this whole, uh, this whole income fund situation is when you're an investor and you go and look at that, uh, that you know that the the industry jargon is a fact sheet or monthly disclosure document uh, minimum disclosure document, sorry. And and you see, you know that fund a is is an enhanced income fund and it's paying 12% a year. And then you go and look at the average and the average is eight as an example. That should not be a reason for you to go and cash in everything you've got in the world and put everything into the fund that's suddenly paying 12. What that should be is a big red flashing light to say pay attention.
Speaker 2:In the world of income funds, money market and enhanced income funds, it's not possible for a fund to be low risk and do two or 3% a year more than everybody else. It's just not. That's not the case. That means that that fund manager has been phenomenally lucky or overexposed you to the wrong asset at the wrong time, and it's a bit like riding a bull. They've ridden the bull and it worked for them for one or two or three years or whatever it is. But what you know is the bull will always win. The bull will always throw you off. And so with the low risk money and that's what this is money market funds and enhanced income funds are your low risk money the last thing you should be doing is taking the maximum possible risk you should be looking for. What you want is the best return at the most reasonable risk. It's a risk and return decision. It's not. Let me just focus on return, return, return, because you're missing the trick here. The trick is you could lose money permanently by chasing just return.
Speaker 2:So I'm not going to ask you to comment on that one, kellen, but I just think my view is it's almost unforgivable for these income fund managers to be taking excessive risk just so they can attract assets, because that's what they're doing. They're in the performance horse race of showing themselves being better than everybody else by showing a higher return, but not emphasizing the point that they're taking a lot more risk on what is a low risk asset. And what's devastating about this is that it will make investors wary of income funds, and the bulk of income funds are fantastic. The bulk of income funds are fantastic. The bulk of income funds are well managed by responsible people, and so you can hear I'm a little bit upset about this and I just think it's sheer greed.
Speaker 2:Sometimes it's not like these fund managers didn't know the risks they did. They thought they could manage those risks Somehow. They're way better than the rest of the industry and unfortunately, the way you're way better than the rest of the industry and unfortunately the way you become way better than the rest of the industry, is you do 0.1 or 0.2% better than your peers, slowly but surely, month after month, year after year, and then you see the difference in a great manager versus the cowboy taking the risk of riding the bull.
Speaker 3:I think that's absolutely correct, warren, and I would just point out as well in this category, probably more than any other category, fees really matter. So when you're assessing income funds, like you say, you're not necessarily looking for the one with the highest yield because that's presumably the one which may be taking unnecessary or unrewarded risk for investors rewarded risk for investors but here you know, a 1% fee saving or half percent fee saving could mean the difference between, say, an 11% return and a 10% return, which is, you know, 10% more return on your money. So that really, I think matters in this category more than ever, where there's not much variability of returns. So just one thing to look out for, and I'd say another one investors could look out for when scrutinizing the income funds that they're choosing, is a really good measure of the sort of interest rate risk in your portfolio, something that's called duration.
Speaker 3:It's a statistic you'll see on many income fund fact sheets and very simply, what this means is it's the sensitivity of that income fund to a 1% move in interest rates, or yields more accurately on a fund, what that means is if, from this point out, let's say, the fund has a starting yield of 10%, if interest rates were to move up by 1%, the fund would lose 2% in capital, and so your starting 10% yield will actually fall down to 8%.
Speaker 3:Conversely, if interest rates fall by 1%, your starting yield of 10% goes up by 2% right Two times the change in interest rates. You'll go up to 12%. So it's also another way of assessing some of the risks that are inherent in the fund that you may be choosing, and it's not to say that funds with zero or no duration are necessarily good or better. Those ones are just taking on more credit risk versus interest rate risk. But it's all a balancing act. It's not as complicated as it sounds, I promise, but there are, I think, some things that investors could could, arm themselves with when selecting income funds and I think that's the point about honest the honest money shows.
Speaker 2:You know, we we're not aiming for you all to be experts by the end of the show. What we we're aiming for is that you listen to this and the next time you're faced with a decision, you know another one or two questions to ask or another one or two pieces of information to go and search for before you make a very important decision with your critical capital. So I think that we're definitely running out of time, kellen, and you know I was prepping you before the time that we always ask new guests to our show my very favorite question. So if you had to meet your 18 or 21-year-old self now, what would be the one life lesson that you would love to give yourself at that point?
Speaker 3:at that point. I think that the most important is to actually embrace your youth. When you are starting out your career or you're entering in a new industry, your youth is probably your number one asset. People take very, very kindly to sharing the knowledge and the experience that they've gained, and particularly with the young person who's really eager to learn. So use your youth and don't be shy to ask lots of questions to people that you look up, to, people you want to learn from. Carve out some time to go and sit down with someone to understand you know what made them successful.
Speaker 3:That's always been something I've found particularly valuable as I've progressed through the industry is sort of the time that people have taken to help me sort of get up the curve, and I think that you know that doesn't work forever. I don't think you could be, you know, like much older and much more established in your career, asking very, very sort of basic, fundamental questions. But these are all the times where you really are crystallizing your knowledge and equipping yourself for the future. So, yeah, take advantage of your youth in the work environment.
Speaker 2:Kellen Potier. I'm a solution strategist at 10X Investments. That was a fantastic show. I think you. I've only been doing this for nearly 30 years and you taught me two or three things today that I probably should have known and I didn't, so I appreciate that. Thank you very much and thank you for your time. I'm sure our listeners have gained some really great insights from you.
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