Investment strategy

  • Author : Alex Bowden
  • Date : August/September
ABOUT THE AUTHOR: Alex Bowden is Investment Director at Smith & Williamson

Capital preservation has typically been the core concern for trustees, but never more so than now. In the past decade, the world has suffered two severe recessions, which have brought about a profound lack of trust in riskier asset classes. Some equity markets have produced a lower real return than cash and bonds for the first ten-year period in living memory.

It is not just the riskier asset classes that have been affected, however, and the greatest concern for trustees today is how to manage cash. So what has changed since the 2007-2008 crisis?

Uncertainty now troubles bond investors and even the cash markets. For investors in government bonds, there are two main risks: credit risk and interest rate risk. The increase in credit risk is most obviously manifested in peripheral European governments, as the sovereign debt crisis rumbles on. Today, with the possibility of default among some economies, cautious investors are avoiding parts of the European sovereign market. This is making debt issued by Germany, the US, UK and other highly rated governments expensive, as a result of a ‘flight to safety’. Yield on US ten-year government bonds has collapsed over the past 30 years from around 15 per cent to less than 1.6 per cent today.

For trustees used to relying on cash, the situation is equally challenging. Before the credit crisis, with interest rates in the US, for example, at 5.25 per cent, many clients were satisfied with using cash deposits to support income requirements. Moreover, with the Consumer Price Index averaging 3 per cent over the cycle, it was possible to achieve a reasonable real return without too much risk to capital. Cash was a safe haven.

This scenario has changed. With interest rates at record lows, cash is generally producing a negative real return. Furthermore, with so much uncertainty surrounding the banking sector, the perception of counterparty risk is heightened. To avoid short-term market volatility there is still a case for holding cash tactically, but in the longer term, cash may not meet a trustee’s key requirements of capital preservation and income generation.

Against this backdrop, trustees should discuss alternative investment strategies with their portfolio manager, bearing in mind their specific objectives and tolerance to risk. Each situation is different, and this is vital when deciding on asset allocation.

I have referred to government bonds above. Of course there remains some comfort in lending money to governments where one can be confident of being repaid. However, by most normal metrics, sovereign debt appears very fully valued after a long bull market. Trustees who consider government debt as an alternative to cash might want to look at inflation-linked issues, where the real value of invested capital is protected. However, this is not an attractive asset class for income.

For a higher level of risk, the corporate bond market offers benefits. Corporates remain in a stronger financial state than governments or consumers and, with good credit analysis, it is possible to invest with some confidence (although diversification is wise). Corporate debt offers better yields than government bonds and while the interest rate outlook remains benign, capital gains are possible. Focusing on higher credit ratings and limited duration, this can be an attractive alternative to cash.

Taking a further step up the risk curve, trustees might consider the equity market. Certainly equities are more volatile than other asset classes, but it is unusual for equities to underperform for long periods, so today might present an opportunity. For trustees with longer time horizons, volatility may not be such an issue, and there are large world-class companies with excellent brands, robust fundamentals and strong cash flow, paying attractive and growing dividends (better than bonds and much better than cash). If circumstances are appropriate, this might be an opportunity for trustees to consider increasing exposure to this asset class.

The short-term outlook is unclear, with both economic and political uncertainty weighing heavily on markets. Asset allocation choices should therefore be made with caution and recognition of short- and long-term objectives. Despite this, the psychological certainty of holding cash should not be confused with the genuine and vital security of achieving a real return on investment.


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