Return Free Risk

As professional investors we are always looking to maximise return and reduce risk for our clients; diversifying across different areas (asset classes i.e. property, gold, US shares, UK shares, etc.) is a tried and tested method. But what else do we do to try and help maximise returns for our clients:

  1. Focus on goals – understanding a client’s objectives and when they may need capital helps ensure that we have the required flexibility at the right time.
  2. Encouraging clients to hold an ‘emergency fund’ in cash; over recent years this has been a bit of a struggle due to poor interest rates on cash and strong returns from property and stock markets. But our clients knew these strong returns couldn’t last for ever, and we wished to ensure that when a crash happened our clients wouldn’t have to sell assets at historically depressed prices to meet their short-term expenditure needs – they could turn to cash.
  3. Rebalancing – we focus on risk – if the riskier stuff does well then to maintain the appropriate level of risk, profits need to be turned into cash.
  4. Keeping costs under control – the less that is paid to fund managers, us, and product providers then the more that is retained for our clients, enhancing returns.
  5. Maximising tax efficiency – getting reliefs, using allowances and exemptions super-charges returns and reduces the impact of losses.
  6. Trying to ignore ‘short term noise’ to protect medium to long-term returns. It is this area I would like to focus a little on.

Since 2008 we have been concerned about the impact of quantitative easing and low interest rates on the medium term returns from capital held invested in some subclasses of  the ‘debt and loans’ asset class (particularly Gilts, Treasuries, Corporate Bonds).

  1. Quantitative Easing has provided governments with capital to repurchase their own debt. Governments are both a huge ‘supplier’ of debt and a very significant purchaser of that debt. When the demand drops so inevitably will the value of the asset. Indeed, were it not for Coronavirus, we believe that Quantitative Easing would be now have been reversed, interest rates generally would have risen, and therefore fixed interest investments would have fallen in value.
  1. Historically low interest rates – a reduction in interest rates sees the price of that debt increase. If I lend you £10,000 today over 10 years at a rate of 0.5% per annum you are repaying me £50 each year and will return the £10,000 at the end of 10 years. If interest rates in the general market fall to 0.25%pa then to get the same £50 of income I would need to loan you £20,000. But when interest rates rise then the opposite can expect to happen.

Quantitative Easing has continued for a longer period than we expected, and reductions in interest rates have gone lower and for longer than we anticipated – but then we could never have foreseen Coronavirus or the impact that this would have on the world economy.  Therefore, over the last few years, we stuck to our strategy of minimising our exposure to traditional government and corporate debt. We recognise there is a need for exposure to loans and debt to diversify risk but we have looked to protect clients from what we see as an inevitable outcome for traditional debt – a reduction in value. Even now, knowing about Coronavirus, we see these investments at this stage in their investment cycle as high risk with relatively low return – big downside and very limited upside. The assets we continue to put our faith in this asset class are:

  1. Freehold Commercial Property – the investor owns land that is leased to the owners of commercial property. A rent is paid for the lease (relatively low % of the value of the property) and the owners of the land have a first charge over the property if the rent is not paid. The income is expected to be at higher rates than available from cash, and both the capital and the underlying income stream are relatively secure.
  2. Renewable Infrastructure – the investor owns assets that generate renewable energy that is sold to the government. Again the income is higher than cash and the capital value of the underlying assets are relatively secure as is the income stream derived from them - the move to  greener energy production is inevitable and the government has targets to meet and faces penalties if the targets are not met.
  3. Floating Rate debt – here rather than the level of interest on debt being fixed it rises or falls in line with Base Rate of interest. Falling interest rates in the last couple of years has not helped this strategy – but long-term interest rates we believe could increase. Coronavirus has had a huge impact on this; if the market perceives that a borrowing company will default, the asset value is corrected downwards.

We may continue to be ‘wrong’ in the short-term – some German government debt has a negative interest rate, so it is not impossible for further reductions, but on a historical basis, notwithstanding Coronavirus we believe that the developed world is closing in to the time when the tide will turn. So, it is the view of our investment committee that we remain light in fixed interest investments and steer away from government debt.

Please note that past performance is not a guide to future performance.

Article published: 14/05/2020

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