How investors can protect their gains
There will be those who, through skill and good fortune, have hung on to the lion's share of their investment portfolios over the past three years.
However, the credit crunch and the policy responses have created such an unusual, and unprecedented, investment environment that few can be confident of repeating the trick over the next few years.
On one hand, this year's Barclays Equity Gilt Study suggests investors have made nothing out of equities over the past 10 years. But with developed market sovereign risk at an all-time high, government bonds look unappealing.
Corporate bonds have been unusually volatile and valuations look rich. What are the choices for those looking to preserve capital without simply riding out volatility?
Fixed income is the traditional route to protecting gains, but huge borrowing by developed market governments has raised the stakes in sovereign debt to the point where several large nations are either at risk of a downgrade or of defaulting on their bonds.
In the UK, the gilt market faces downward pressure as the Bank of England withdraws quantitative easing, and it is vulnerable to a downgrade by credit rating agencies until politicians develop a credible plan to cut public spending.
Equally, corporate bonds look less attractive after a strong run of performance saw the average UK corporate bond fund rise 19.9% over the past 12 months. Continued outperformance of this magnitude seems unlikely and, at worst, valuations now look too high.
Bob Yerbury, chief investment officer at Invesco Perpetual, says: "The recent past has reminded investors that they can lose as much money in fixed income as they can in equities."
Leaving the money in the bank
And then there is cash. Yerbury argues that the biggest risk for investors is to leave their money in the bank, earning nothing and being eroded by inflation.
In January, inflation was running at 3.5%. The best instant-access savings account was paying just 3% before tax.
What are the options to deal with this environment? For those who prefer to stick with a more traditional blend of asset classes, it is a case of taking a smarter approach to risk management and diversification than simply looking at recent history.
David Jane, head of equity investment at M&G Investments, says: "A lot of rubbish is talked about risk.
"Risk tends to be the worst thing that happened yesterday. Models are good for chemical processes, but investment management just doesn't work that way."
He believes it comes down to taking a "real world" view of risk and being aware that risk has a relationship to valuation – if things are cheap they tend to be less risky.
Jane says it is important not to be too blinkered and to incorporate more than one view into a portfolio. He adds: "We don't know what will happen next, but we know the balance of probabilities.
"We don't want to be positioned where if we're right we do fabulously well and if we're not everything goes wrong."
The appeal of equities
With a real world view of risk, equities may not look so unappealing. Yerbury says the picture from the Barclays Equity Gilt Study is misleading: "From 1980-81, there was an extraordinary rise in equities and by 2000 they were really overvalued.
"Now we are only just emerging from recession. Over a 20-year period you have never lost money in equities. If an asset class has done nothing for 10 years that is not the time to give up, that's the time to invest."
It is difficult to make a case for most areas of the fixed income market, but emerging market debt offers one solution.
Mark Harris, head of multi-manager at Henderson New Star, has stuck with buying the debt of those countries with surpluses, largely in emerging market countries and Asia.
There are several successful emerging market debt funds, including those from Investec, Fidelity and Threadneedle.
A number of investment managers protected capital in the difficult markets of late 2007 to early 2009. Mick Gilligan, head of research at Killik & Co, points to Philip Gibbs at Jupiter, whose Financial Opportunities fund rose 1.7% in 2007 and 7.3% in 2008.
Some 204 funds lost less than 5% in the downturn of November 2007 to February 2009, of which more than half were fixed income funds.
Among the remainder, there was no fund in the UK all companies sector, but two in the Japan sector, two in biotechnology, four in balanced managed, and five in the cautious managed sector.
Picking those funds would have taken considerable skill, and the majority of non-fixed income funds that preserved capital were absolute return funds. These are the latest and most successful attempt to bring hedge fund-like returns to the retail market.
Absolute return funds tend to be benchmarked to cash and have generally delivered as promised. Only one fund in the IMA absolute return sector has lost money over three years: the Elite LJ Absolute Return portfolio, down 5.8%.
The average fund is up 14.2%. Gilligan says: "A typical equity fund will have an exposure of 100%, whereas an absolute return fund will have exposure of between 0 and 50%.
These funds have generally worked to preserve capital, and have not sustained losses over any period of more than 5 to 10% even when markets have been down more than 30%."
He adds that most absolute return fund managers will protect capital even over relatively short periods: "In practice, most managers are looking over relatively short periods, otherwise they will fail to attract capital."
Gavin Haynes, investment director at Whitechurch Securities, says each fund will have different risk controls and positive returns are not guaranteed, but plenty of funds in the sector are grinding out steady returns.
Gilligan likes the BlackRock UK Absolute Alpha and Cazenove UK Absolute Target funds.
There are more esoteric solutions to the problem of short-term capital preservation.
James Daly, investor centre representative at TD Waterhouse, says: "Selling off a portfolio because you don't like the look of the equity market for the next year is a huge undertaking for a private investor, and it's fiddly and expensive."
Private investors may not want to sell out for tax reasons.
If the market falls, investors exercise the option and the money made from the option compensates them for losses on the long-only investment portfolio. The downside is limited to the price of the option because it does not have to be exercised.
Websites such as Société Générale's warrants site can help determine the type of warrants needed.
Investors can use contracts for differences or spreadbets. Here, they put down a deposit and can go short on the market. But this can be dangerous. If the FTSE 100 rises, losses are – in theory at least – unlimited as the FTSE 100 could continue to rise ad inifinitum.
Although investors should be protected by the rises in their underlying portfolios the hedge must be perfect. It is not enough to hedge the FTSE All-Share when the underlying portfolio is in the FTSE 100.
Most professional investors only use these techniques in a crisis. Yerbury says: "It could cost up to 3% per year to hedge losses using futures. Such is the power of compound interest it isn't worth doing this for any length of time. I would only do it if I were near retirement."
Capital protection solutions are available, but there is no magic wand. For every risk hedged something is sacrificed.
Are structured products an alternative?
In their best incarnation, structured products should offer a halfway house between cash and the equity market. They generally promise a certain level of return, related to the performance of an index, but with the security of a capital return after a certain number of years.
Structured products have been dogged by controversy. 'Precipice' bonds got their name because investors lost £2 for every £1 fall in the index if it dropped below a certain point.
Then came Lehman Brothers. The investment bank had been the counterparty on a number of structured products and many investors found their 'guaranteed' products were worthless when the bank went bankrupt.
Counterparty risk assessment has been tightened, with many issuers now looking to daily prices on the credit default swap market to judge default risk rather than behind-the-curve credit rating agencies.
The trouble for many investors is they require tying up money for five years or more so do not solve the short-term problem of capital preservation. They also tend to be expensive.
This article was originally published in Money Observer - Moneywise's sister publication - in April 2010
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Structured products offer returns based on the performance of underlying investments. Many products are linked to a stockmarket index such as the FTSE 100 or a “basket” of shares. There are generally two types of product, one offers income, the other growth and investors have to commit their capital for the prescribed term, usually three or five years. The investment is not guaranteed and if the index or basket of shares does not perform as expected over the term the investor might not get back all their capital.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
A stockmarket security (a form of derivative) issued by companies on their own ordinary shares to raise capital. A warrant has a quoted price of its own that can be converted into a specific share at a predetermined price (called the conversion price) and future date. The value of the warrant is determined by the premium of the share price over the conversion price of the warrant. Warrants give the same economic exposure to an underlying security without actually owning it, and cost a fraction of the price of the underlying security.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
This is effectively paying interest on interest. Interest is calculated not only on the initial sum borrowed (principal) or saved (see APR and AER) but also on the accumulated interest. The more frequently interest is added to the principal, the faster the principal grows and the higher the compound interest will be. Compound interest differs from “simple interest” in that simple interest is calculated solely as a percentage of the principal sum.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.