Podcast: Banks, blockchain and ‘swimming naked’

Nigel Barnes

We’re thrilled to have been joined by Michael Jordaan – CEO and founder of Montegray Capital, Chairman of Bank Zero and former CEO of FNB – for our first podcast of 2023. Joining him to talk about some of the things that are currently top of mind for investors in the financial sector were Kokkie Kooyman, global financials portfolio manager, and Nigel Barnes, our head of business development. They discussed the opportunities in the financial sector and the broader investment market, the challenges banks are facing, blockchain and decentralised finance and how all these factors shape the portfolio of the Denker Global Financial Fund.

Nigel Barnes:

Michael and Kokkie, thank you for joining me for the first Denker Capital podcast of 2023. It’s fantastic, Michael, to be here in your boardroom. Stellenbosch is putting its best foot forward this morning. It’s really great to be here and thank you, both of you, for taking some time.

Michael, I listened to your Think Big interview yesterday with our friends at PSG and there were a lot of good themes there. I want to dive a little bit into one or two of those areas but not cover the same as some of our listeners would have heard yesterday. And to frame all of this, as normal I like to sit in the position of the investor and try and ask relevant questions that the investor or the allocator of investments is really thinking. The focus today is on the financial sector and to open this up, let’s start there.

Based on the current macro environment, how do you two see the financial sector – in terms of locally, globally, interest rates and the inflationary environment? Michael, do you want to start us off and then, Kokkie, you can interject as we go along?

Michael Jordaan:        

One of the advisors to Bill Clinton said that if he dies, he would like to come back reincarnated as the bond market. The reason he said that is the bond market terrifies everyone. But, strange enough, that has been debunked of late by the massive action that central banks all over the world have taken and resorted to buying bonds.

So, we’ve just come through an incredible period where the bond market has been rendered impotent and interest rates have been near zero for the longest period that it’s ever been in history – that is from 2008 until 2022. So, for nearly 14 years interest rates have been close to zero, at least in developed markets. And that has massive, massive implications for the pricing of all assets, because assets, after all, are a discount of future returns. And if you’re discounted at zero percent, it means that in theory the profit you’re only going to make in 100 years is worth as much as the profit that you would make next year, which is why growth stocks and many other speculative assets actually shot up so much.

A zero interest rate affects everything in the economy – it affects economic growth; it affects households, how much money they have left to spend after their mortgage payments or what type of mortgage they can afford; it affects the decisions of corporates, whether they are going to invest in CapEx or buy back their own shares. So, this single interest rate, the one I would like to be when I’m reincarnated in a world of global interest rates is the most powerful thing in the world.

But it’s been zero for too long, and because it’s been zero for so long, our risk management has not been appropriate. It’s been possible to invest in zombie companies. It’s possible that companies have continued to exist because they didn’t have to pay back their debt or service their debt because the debt servicing prices were so low. And it is completely unlikely that we will emerge out of this unscathed. Interest rates are going up quite fast. The impact of that hasn’t yet flown through the entire economy. I believe the repercussions on investment decisions, on everything in the economy, are massive and we’ve only just started this process.

Nigel Barnes:

Kokkie, can you comment here in terms of the debt levels that we might see within the banks and other financial institutions rising? Is that cause for concern?

Kokkie Kooyman:

For banks, initially higher interest rates are a huge positive. I mean, we’ve been saying the whole time it’s like manna from heaven for them. So, yes, high interest rates really have a positive impact on the net interest margins, on the return of capital.

I happened to visit a bank in December in Europe. We were sitting there and, with the model in front of me, I suddenly realised their loan book over the last ten years had more than doubled, I think three times, but the interest income was the same, and that was a squeeze on margins. So, they were working twice as hard and obviously trying to save money on expenses and suddenly, in the last six months, this is end of 2022, the net interest margin shot up. And that’s really what’s happening.

Secondly on the banks, and I’d like to hear what Michael says too, post-2008 – we’ve been saying this the whole time – the impact of the regulatory changes will be seen now. It’s been much more difficult for banks to be their normal free-lending selves.

Bank balance sheets and their loan books are very clean and so the big surprise for the market (we think it is wrong here) is that the bad debts are going to be a lot lower than expected. What corporates and the banks have exposure to are a lot stronger as well, I think, than in the past cycles. I don’t know, Michael, if you agree with that.

Michael Jordaan:

Yes. I’ve found in the past that some of the bank analysts, certainly not Kokkie, but some of the banking analysts globally are actually quite lazy in understanding the impact of interest rates on balance sheets and on income statements. In very, very basic terms, high interest rates are great if you have a deposit franchise and negative if you have a lending franchise. And obviously most banks will have both, but they’re completely separate profit drivers and need to be understood not as a mix but separately.

In other words, when you raised your deposit, have you used your treasury function to transform or fix the maturity of those deposits? So, it could be that you don’t share as much as you can when interest rates go up or down. So, that’s the one thing analysts need to understand. And on the credit side, while Kokkie, of course, is broadly correct saying regulators have prevented banks from maybe taking the worst risks, it’s by no means clear yet what people have done over the past 14 years where rates have been close to zero.

As Buffett said, you only know who’s been swimming naked once the tide goes out. The tide is going out now. The fascinating call that investors have to make, at least bank investors, is who were rigorous in their credit assessments, who didn’t just grow market share for the sake of growing market share, who have some big negative surprises that are going to come.

I dare say that I have confidence in the South African banking sector. I don’t think we’ve gone overboard. But anywhere where you’ve seen growth that is too fast, whether it’s, I don’t know, the Chinese property sector, for example, we haven’t at all started dealing with the bubbles that have formed during this period.

Nigel Barnes:

Kokkie, how easy is that for you and the team to really analyse?

Kokkie Kooyman:

We spend a lot of time modelling past behaviour. So, often your best predictor is what happened in the past. If you look at the banks who’ve always had the lowest cost of risk and the lowest bad debts, generally that’s in their DNA and that will stay.

Secondly, as Michael said, we look at those who didn’t grow their loan book excessively and loan growth until 2021 was actually very subdued compared to previous cycles. So, you’re looking for those banks that have been conservative. Interesting, a lot of the excesses that took place were in the lower end of the market, the so-called buy-now-pay-later space. A lot of the fintechs came in because of the low cost of money. Their funding was very easy and they just lent out to the lower end of the market and so now we see a lot of stress there. And so when we invest, we’ve got very little, in fact, nothing in that space. So, the bubble there’s been pricked. If you look at a lot of those guys, Stone, Klarna, etc. – their bad debts are just three, four, five, six times higher because they were irresponsible in the lending.

Nigel Barnes:

So, the historic interaction you’ve had with these organisations over time, Kokkie, understanding how they’ve managed their loan books in the past is really the benchmark for how you look at things right now?

Kokkie Kooyman:

Yes.

Nigel Barnes:

So overall, the increase in interest rates is positive for margins and profitability and earnings for these organisations. And because of the regulatory controls, we should see more control than we might have seen in the past. Would you agree? Does that sum things up? It’s quite a positive venture.

Michael Jordaan:

The answer’s “yes, but…”. So, if I can just mention one big figure, it’s the total amount of debt in the world, which is $300 trillion. To put that into perspective, that’s 350% of global GDP. Three and a half times GDP is global debt.

Now, at the turn of the century it was 200%. So, in 22 years it’s gone up by 1.5 times whatever GDP is now. Now, the point Kokkie’s making validly is that not all that debt has come through the balance sheets of banks or sits on the balance sheets. Some of it may have been arranged by the investment banking components. That debt, should something go wrong – and something will go wrong when interest rates go from zero to 5% – will have a wider impact on the economic system and the financial system and will find its way back to banks. For example, it could have lent some money, a small amount of money, to a corporate who had a bond issue. But when they start struggling to pay the bonds that they have, that doesn’t mean that the corporate loan isn’t also affected.

Or, maybe more ominously, the risk weighting that banks typically have when they invest in government bonds can be zero. It is seen as “risk-free” (in quotation marks). And it is by no means risk-free. Countries that have debt to income ratios in excess of 100% are not risk-free and that includes the biggest of all, the United States.

So, while the regulators have been smart, here’s one huge blind spot, for example, that when banks invest, it’s a form of lending, a form of credit, in state bonds, it’s seen as risk-free. I’m telling you, it’s everything but risk-free. Now, those things are going to be revealed as the tide goes out. Many have been swimming naked.

Kokkie Kooyman:

Where Michael is totally right – you’ll recall the European debt crisis (2012/13 to 2015), when the risk was that Italy and Greece might fall over and the banks had a lot of European bond exposure – so, I agree, that is the biggest risk out there, that government debt that we see as safe appears not to be safe and that you have a repeat of that. Actually, it did happen, if you saw the Greek banks.

Now, Greece has improved dramatically but all the debt they have is at a fixed rate. So, they’re looking good but someone is carrying that risk. So, the European Central Bank is sitting with that Greek bank and paying more for funding but the servicing is at a low level. So, I agree. But that scenario, where you have the risk of government default, will cause a global recession.

Nigel Barnes:

In terms of the portfolio, Kokkie, taking all this into consideration, how have you been shaping the portfolio on a global basis?

Kokkie Kooyman:        

I’ve been around for a few years. We know the banks that we have invested in well, and we’ve always focused on the quality of management and historic track record. At the moment there’s about 20% in US banks and a lot in European banks, also about 20%, but they are very mispriced in terms of high dividend yields. But I agree, the risk of bond defaults is high.

Then there’s 20% exposure in the property and casualty insurance sector, which is doing very well at the moment, and some emerging market banks in India and Indonesia (countries that are actually still growing at 7% or 8% real). So, we’ve diversified it a lot.

Nigel Barnes:  

Moving on but staying very much within the financial sector on the same theme – Michael, for many years you ran a large listed diversified financial services business. What other challenges would you be seeing if you were sitting in that chair today? What would be the big challenges keeping you awake at night?

Michael Jordaan:

Of course, there are the business basics. You’ve got to have happy customers and have happy staff members but, to make it a bit more technical, all banks are actually fintechs. The label fintech isn’t just for these new start-ups, banks are run on technology and they have massive technology investments.

But much of that may be legacy because the new technology that is being developed now is cheaper, is more employable, can be implemented faster. And there’s this saying in the world which goes beyond banking but, how long is it going to take the incumbents to get innovation? Are they going to be able to do so before the start-ups get distribution? That’s the big challenge that’s happening between incumbents and start-ups all over, as well as in banking.

So, with the knowledge that I have now, being Chairman and part of the founding team of Bank Zero, is that it is possible to start a new bank at a fraction of the cost of an existing bank. When I say fraction, I’m not talking 1%, I’m talking a fraction of 1% of what it costs for an existing bank.

So, were I to run a big old incumbent bank, I would be terrified. As it was said, only the paranoid survive, and I would be looking at ways of hedging the risk to make my cost of intermediation much, much less. So, I think that is possibly the most significant challenge for banks, insurers and asset managers out there. There are new technological solutions, and maybe we can talk about crypto later, that can offer the same kind of solutions to customers but at a fraction of the cost at which it’s being done today.

Nigel Barnes:

Kokkie, I want to get into decentralised finance and crypto and other areas in a second, but in terms of shaping a portfolio and the large listed financial groups that you look at, have you started to tilt more towards those that are investing in some of these new technologies and are really aware of this?

Kokkie Kooyman:

No. Well, yes and no. Michael will tell you that generally the innovators tend to be very expensively priced and the problem is initially you don’t know who’s going to win. So, a lot of the innovators have actually fallen over and grew too fast. They still tend to be monoline (have one product and do very well with it) but then to really compete with the bank and offer mortgage, car, etc., etc., takes time.

Every bank management we see, we ask those questions and we check whether they are aware of the challenges as well. Do they stay awake at night and worry?

One of the banks we did actually invest in was Signature Bank. And it’s a fascinating story. They were bankers to seven of the crypto exchanges and got in very early and had growth in stablecoin deposits, so much that it became 20% of the deposit base and obviously this was free money. It did very well. And then, when we had the Terra Luna collapse and especially the FTX collapse, even investors in stablecoin suddenly started panicking and those deposits flew out again.

I think in times of innovation, when there’s a bubble, sometimes there are initially excesses. So, we’ve waited. We stayed with Signature Bank and it’s come back from $300 at 3x price-to-book back to $100 at 1x book value. So, we’re investing now again. In terms of innovation, you’re going to get a second and a third chance to invest but we’re certainly looking at all the players the whole time, interviewing them and trying to stay abreast.

The first wave is most probably over. I’d love to hear what Michael thinks as to higher cost of capital. Is innovation dead? We know it’s not, but it’s more expensive I suppose.

Michael Jordaan:

So, Kokkie, what exactly is your question? I’ve got lots of answers but I want to make sure I answer the right one.

Kokkie Kooyman:

So, we’ve seen also in the previous tech bubble in 2000, that innovation comes in spurts, driven often by things… This one is driven by low cost of funding. So, do you get a real slowdown now and blockchain just becomes unimportant for five years, in the background there you have guys in labs working, or do you think it’s going to increase and be mainstream?

Michael Jordaan:

If we’re talking about blockchain in particular, the same basic principles apply that apply to nearly all the other technologies we’ve seen out there, whether it’s AI or 3D printing or genetics that are designed. And that is that if something gets discovered, it gets hyped, everyone gets very excited about it and at some stage that hype is overdone, it comes down, and then it may actually go undercover for a long period.

AI was discovered decades ago and it never came to fruition. Suddenly we have ChatGPT and now we’ve realised that there’s a very real example of how it can be very useful to nearly all of us in all of our endeavours. So I believe it will be, with blockchain.

I happen to be a bull on crypto and a bull on blockchain. I think there are many, many practical ways in which it can improve life. But so far not many of them have become evident. I know there will be people out there that disagree with me vehemently, but it’s not come to the popular imagination, other than as a speculative currency. Now, that for me is quite separate from the use cases for which you can use blockchain.

The one positive about the fact that the market has certainly also been in a bubble situation is that those developers have been able to attract a lot of capital, also free capital, which has allowed them to experiment magnificently. So, the amount of work that has been put in by developers in the blockchain or the decentralised world is actually quite immense.

So, I remain a bull but it’s also not yet clear who the winners will be there. Just like at the beginning of the Internet we weren’t able to say that somebody like Mark Zuckerberg would become one of the world’s richest men through Facebook. In hindsight it seems quite easy. Or that Amazon would be the e-commerce site. I think we’re at those very, very early days where it’s easy to be bullish on the entire macro promise that blockchain can deliver but at this stage it’s quite difficult to say who the individual winners will be.

Kokkie Kooyman:

But the development on blockchain is continuing because it has significant advantages over the current processing. I know banks like JP Morgan have built an in-house blockchain for their clients and just the lower cost and speed of transaction is…

Michael Jordaan:

…and the auditability and the trust that you get with it. Although I’m supposed to give a balanced view, it is not in every single instance the best technology to be used to solve a problem. There are certain cases where simply having a centralised database is better able to solve the problem. But if that centralised database or system comes with a monopoly that behaves like a monopoly, then decentralised finance is a far superior alternative.

Nigel Barnes:

I think it’s fair to say that there’s one very prominent scandal happening at the moment globally in this area, the FTX scandal, but the regulators are catching up right? That should give more comfort and start to develop this whole segment as we move forward. Would you agree?

Michael Jordaan:

Yes. So, FTX is a significant fraud, one of the largest I think we’ve experienced. Interestingly, it is not a decentralised protocol that has failed, it’s actually a centralised institution. Obviously, everything they did had to do with crypto currencies but they themselves were a centralised institution and there was a lot of failure in there.

And those failures are basic errors of things that a properly regulated bank would never have been able to commit – loans to subsidiaries and large exposures and unhedged exposures and currency risks to the extent that they have. So, it’s good that regulators are catching up, as they always do. They are mostly behind the innovation and play catch-up, particularly when these large things go wrong.

But that would be regulation of a centralised institution. I think what probably also needs to happen, and is increasingly happening in the world, is the way that regulators perceive crypto currencies (What are they? Are they commodities or currencies?) – bringing them into the regulatory net, and when they do so to protect consumers. I think that is the right thing to do because a lot of naïve consumers have fallen for crypto as a get rich scheme, which certainly is not what it should be and there should be, for most people, definite portfolio limits as to how much they should invest in these types of currencies. Therefore, I think the real players are actually welcoming regulatory intervention sector.

Nigel Barnes:

Kokkie, I’ll put you on the spot. Roughly what’s the exposure within the portfolio at the moment to these new areas (you talked about crypto exchanges, etc.)?

Kokkie Kooyman:        

Let’s call it 5%. We are also invested in a small private equity manager who focuses on emerging market fintechs listed as VEF, and that share price also collapsed. The individual businesses are still doing exceptionally well. They are in Brazil, India, etc. But investors are just fleeing those investments and we are picking some up there as well.

The same with Signature Bank. The client behaviour and investment behaviour goes in cycles, but the bank was not irresponsible in growing that area and so that’s really where we’re slowly picking up.

Having said that, all the banks we talk to are working on or investigating blockchain but slower on DeFi and ways of crypto on-ramping and off-ramping, because as the regulators get involved, they first want to see what regulatory changes there will be.

Michael actually recommended, about a year and a half ago I think, that I read Steven Sidley and Simon Dingle’s book ‘Beyond Bitcoin…’ and the unfortunate title with it, “…and the End of Banking”. I was going to ask him are we now in ‘Beyond Banking and End of Bitcoin’. But that book I would still recommend because it really gave me a good foundational insight into what was happening and who were the players and what they were doing.

But where they were wrong was the whole liberalist theory of permissionlessness. But, the interesting one is the trustlessness. I read recently that aid agencies are increasingly using blockchain ledgers for distribution of funds because it is transparent, it’s visible, so you can give the money to the Kenyan Government and you can see exactly where that money goes and where it arrives. So, if used correctly, it cuts down on corruption everywhere.

Michael Jordaan:

And those are the use cases that over time will develop. That seems to be a very interesting one. One in South Africa I find interesting is where people generate solar power, with all the loadshedding, but sometimes they aren’t available to use it – maybe on a holiday house or they’re not there the weekend – and they want to share it with their neighbours.

Now, this type of thing can very easily be built on a blockchain where there are micro payments and at the end of the day they net off what has happened and keep the net settlement. That type of thing would be crazy to run on a spreadsheet or through a normal type of bank account. So, many of these micro solutions are out there, and what’s happening in the world is it’s one massive laboratory and out of that are going to become very, very interesting things.

The cases I’ve mentioned may not even compete with the banking system as we know it because the type of transactions are currently not happening there. It’s not a source of income but it could grow massively. As solar grows in the African continent, you may have all this blockchain-based settlement of electricity usage without ever touching the banking system.

Nigel Barnes:  

Sure, interesting. And Kokkie, interesting to know that there’s a component of the portfolio, from an investor’s perspective, where you’re focused on this area and in touch with this area and learning all the time.

Kokkie Kooyman:

The analysts – Craig, Barry and Ben – are really focusing on the so-called payment space and processing space and, as Michael alluded to as well, it’s the service levels, it’s retuning the digital space, reaching your clients in a more user-friendly way and continuously ranking banks on how we perceive their ability to see the future and work towards it.  Even JP Morgan, one of the largest banks in the world, is way ahead of a lot of other US banks on that space.

Nigel Barnes:

Guys, that’s great. We touched on the broader financial sector and some of the positives and challenges there. We touched on decentralised finance, if I can use that term, and the focus there and some of the things that have happened and the lack of cheap money and how that’s impacting things. I think let’s finish off with a third area.

Michael, I heard you use the comment about ‘where the puck is going’ being the important focus. I know you also mentioned that you’ve got a lot more time to read and think about things than you did perhaps in the past and you’re very focused on solving problems. You also made a very strong comment yesterday about people needing to really pick things up and take their own responsibility and not apportion blame to government, etc. So, that’s all very relevant but in terms of where the puck is going – where do you see opportunities, Michael? I know this is what you do day to day.

Michael Jordaan:

We are in such an exciting world because there are many, many more entrepreneurs all over the world that are trying to solve the problems in front of them and the world’s become flatter. So, if somebody does something successful in, I don’t know, Ohio or in Beijing, you can read about them on the Internet and you try and do something like that in your own country. These type of things obviously didn’t exist 2,000 years ago but even 20 years ago.

And because many of these things are digital and tech type of solutions, the costs of copying them are close to zero. So, there’s a massive amount of entrepreneurship happening all over the world and in South Africa that really just didn’t exist. And that means problems that aren’t just problems, they are all business type of opportunities.

Now, some of these things are difficult to invest in if you only want to invest in listed shares, because it’s either private equity or venture capital. That’s what I do. It’s what I love. It’s risky but it’s very, very energising because you surround yourself with people who are complex problemsolvers and see better ways of doing things. So, that’s very, very gratifying.

So, my message would be to not only invest in listed shares (certainly bonds are boring and also, arguably, quite dangerous, given where interest rates are going) and to add some of your portfolio, personally or outsource it to experts, to venture capital and start-up companies that are going to produce superior growth.

Apart from the fact that it solves problems and it’s really good for making the world better and creating jobs. I can tell you that if done properly, the rates of return that one is able to get out of these types of start-ups is significantly superior to anything in listed markets.

Nigel Barnes:  

Kokkie, so the challenge for you is to keep the focus and as these businesses develop in the finance sector to bring those into the portfolio for the benefit of the fund and through investors.

Kokkie Kooyman:

That’s why we travel the world and, as Michael says, it is hugely exciting to talk to the new players but even within existing banks. For example in Brazil, the two largest banks have a spin-off outside the bank (very clever) – outside the whole corporate thing and they let them run. To go and talk to those guys and ask them what they’re doing… we’re in hugely exciting times.

Michael Jordaan:

You asked me what it would be like running a big bank. I think that is the correct approach, the one that Kokkie has mentioned. If you try and control it too much with your existing culture, your existing HR process, your branding strategy, etc., etc., you’re not going to have the entrepreneurial freedom that those start-ups have and you’re not going to think first principles and feel the pressure there.

But I think it’s very clever for a big bank to say, so I’m going to hedge my bets by having a separate institution that competes against me.  Which is brave, I can see many corporate cultures won’t allow that, but it’s exactly the right thing to do.

Nigel Barnes:

Gentlemen, thank you very much for taking the time. Kokkie, as always, thanks for being on and, Michael, it’s been fantastic seeing you and we wish you all the success for all your ventures this year. Really appreciate your time and opening up the boardroom for us today.

Michael Jordaan:

My pleasure. Thank you.

Kokkie Kooyman:

Thanks, Nigel.

Please contact us for more information on the Denker Global Financial Fund, or if you would like to invest.

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About the author

  • Nigel Barnes

    Nigel’s focus is to drive the business development strategy and lead the sales function. Before joining us, Nigel fulfilled a range of business development and sales roles over a period of 10 years at Investec. While living in London, before relocating to South Africa, Nigel was the sales director at Deutsche Asset Management and a director at Close Finsbury Asset Management. His career started in 1995 and has included consulting work, where his main focus was building strategic partnerships in the financial services industry. Nigel joined Denker Capital in 2018, bringing with him a wealth of local and international asset management industry experience.