High interest current account vs index funds

[Osprey]

Hi all, I'm looking for some opinions and advice please. In South Africa there is a bank offering the following interest on a current account:

The monthly fee is R 4.50 and the rates vary according to various amounts in the account and interest is calculated on a daily basis. You also get a debit card with unlimited free transactions.
(For conversion R10 = USD1 more or less)
R0 – R9,999  -->  5.00%
R10 000 +   --> 4.25%

To me that's a really good rate. I'm wondeiring what portion/amount of my cash to keep in this account and what to put in index funds? Any opinions would be greatly appreciated. I also have a retirement account lniked to my employer and a credit card with R50 000 limit.

[fiveoclockshadow]

This is actually a very complicated question that likely few if anyone here is going to have an easy time answering.  The issue is the foreign exchange.  I don't have any idea if 5% interest in rand is really any good compared to returns in dollars.  In theory the risk free rate of return in all currencies is about the same once exchange is made to a common currency.  So when you see the risk free rate is higher in rand than dollars that indicates the market expects the rand to be loosing value compared to the dollar in the near term.

For example, in the past year the rand has dropped about 20% compared to the dollar.  That means someone holding dollars in an account with an interest rate of zero would have done much better than someone holding rand in an account with an interest rate of 5%.

Read more about interest rate parity here:

http://en.wikipedia.org/wiki/Interest_rate_parity

However, when it comes to savings accounts it can be really hard to tell.  Sometimes rates are higher if you use a debit card a certain number of times a month or direct deposit into the account.  Usually the high rates are capped to a modest balance (less than $15K-$5K).  Here in the US getting an interest rate on an unlimited balance greater than 1%-1.5% is very difficult to find.

Foreign exchange is often extremely volatile which makes this kind of thing difficult to evaluate.

[turboseize]

Monthly fees really eat a good portion of your return, at least with smaller amounts of money.

1kR -> 996R -> you are LOOSING money, even before inflation!
2kR -> 2046R -> 2.3 %
5kR -> 5196R -> 3.92 %
9.999R -> 10444.95R -> 4.45%
10kR -> 10371R -> this only gives 3,71%.


Edit:
I looked up Inflation... and I have very bad news: Inflation (Consumer Price Index) in  South Africa is 5.544%. (Source: http://de.global-rates.com/wirtschaftsstatistiken/inflation/verbraucherpreisen/vpi/sudafrika.aspx)


That's no investment, it's a loosing game. Guaranteed.

[Osprey]

fiveoclockshadow: Thanks for the wiki link, I'm busy reading up on interest rates.
turboseize: I already use it as a current account (best fees available) and was thinking of keeping a higher balance as "emergency."
The CPI is pretty scary but medium term savings at other banks give around 3%, I'm barely making 5-6% from index funds and even less in my pension.
Maybe I'm doing something wrong?

[turboseize]

If you can get the money in this account immediately, it might still serve it's purpose - as a means of storing liquidity. But with returns below inflation, it definitely is a bad investment.

In the long run, your index funds should clearly beat inflation. Where do you invest? I do not know how the situation is like in South Africa, but in the US or in Germany you should expect 8 to 12% on average. This means there may be some years with 25-30%, some years stocks will just go sideways and there are crashes and recessions, meaning stocks may go down drastically, as last seen in 2008. So your 5-6% should not be to alarming, the average return of stocks is just that: average, over many, many years, with wild volatility in between.

You might want to have a closer look on expense rates and fees, though, as they can really eat into profits. Not only are there running fees, but often funds are sold with a premium (which in Germany can be as high as 5%!). Highest premiums will be found at managed funds and lower at index funds, but even between index funds there might be huge differences. These premiums can really kill your returns during the first years... The longer you hold the funds the less will they matter.

Then you want to make sure you're buying index funds that are actually recreating the index by buying stock - and not just tracking  the index's performance buying derivatives. The latter might be cheaper, but they mean a different set of risk - not only the usual stock market volatility, but also risk the bank issuing the derivatives might default. And, most important: only the real, all stock index fund will pay out dividends, which will provide some profit even in sidewards markets.