How low can you go?

One difficulty clients are facing is whether or not to continue investing in perceived low-risk assets, despite receiving negative real returns. Investors have continued to deploy capital towards areas of the fixed interest market, which, ceteris paribus, is guaranteed to provide negative returns once adjusted for inflation. This trend conflicts with traditional-based assumptions that impact investment models (assuming investors are rational) and understanding an investor’s risk profile.

First, the investor’s ultimate goal should be determined along with what risk they are willing to accept to reach it. Goal setting and the analysis of risk and return forms the basis of any risk profiling and investment objective process.

Indeed, the conduct of business rule 9.2.2R “requires firms, among other things, to take account of a customer’s preferences regarding risk taking, their risk profile and ensure they are able financially to bear any related investment risks consistent with their investment objectives”.

However, at the start of this process, the investor and their adviser already face potential challenges as an individual risk profile is at some point subjective. For a risk-profiling question, an investor is asked, for example, what their tolerance is to loss. This answer can be distorted by an endless number of variables outside their immediate investment goal and financial soundness, and needs to be analysed in conjunction with the work completed in knowing your client.

Examining just one traditional assumption, we can begin to see how the conflicts between investment returns and risk objectives are growing.

In economics, ‘utility’ can mean happiness. Economic utility theory assumes every person seeks to maximise their personal utility. It also assumes that utility increases directly with wealth and that rational people will buy risky investments only if they expect higher returns (risk premiums) to compensate them for this risk. This suggests that low-risk investors would need to see higher returns to encourage them to accept additional risk.

Historically, fixed interest has been considered a defensive component of any investment portfolio and provided not just an element of safety but also income opportunities. However, within the fixed interest asset class there are various levels of risk that can be undertaken. Examining just a few of these we can potentially identify a changing pattern of investor risk.

Based on the data in the 2013 Barclays equity gilt study on UK real investment returns, we have witnessed the returns of UK government gilts fall from a real annualised ten-year return per annum of 3.4 per cent, to a return of 1.6 per cent in 2012. Under the same parameters, index-linked gilts have fallen from 3.5 per cent over ten years to 0.2 per cent in 2012.

Meanwhile, a riskier sector within the fixed interest asset class, for example corporate bonds, has moved from a ten-year return of 2.3 per cent to a return in 2012 of 12.1 per cent. To complete the analysis of the defensive part of the portfolio matrix, cash over ten years has delivered a -0.2 per cent real return and in 2012 it fell to -2.7 per cent.

Risky move

This fall in returns from what (apart from corporate bonds) have traditionally been considered as risk-free assets has reduced the potential returns available to low-risk investors from low-risk assets. If we go back to the economic utility theory then we should assume that a rational investor will buy risk assets if they are compensated for a higher return. This is what the investment world has been expecting to see and we are witnessing the first tentative steps in this direction ?– a move towards risk.

Looking forward, the Barclays equity gilt study forecasts that over the next five years, cash will provide inflation-adjusted returns of about -1.5 per cent per annum, with government bonds returning -2 per cent. If they are right in this assumption, low-risk clients and their advisers will face an ever-increasing challenge of weighing up the expected level of risk and return and the asset classes available to achieve their desired outcome.

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser

This article was published in the June 2013 issue