Private client | Preserving wealth in a volatile climate

Variety is the spice of life and there is plenty of variety in the universes of investors and investments. To start with the former, having a traditional broking mindset, I like to establish whether a client is looking mainly for income, mainly for capital growth or for both. Most clients tend to opt for a mix of income and growth, but not always. I do recall two clients in the past that doubted this approach and said it was immaterial to them. One, an engineer, said he just wanted to feel “warmer”, in other words; wealthier, and the other asked: “Does it really matter?” Both thought in terms of total return which is indeed the way we measure most funds these days and both were quite comfortable to realise capital gains should they want to take additional income. However, they would probably not have been comfortable to pay UK Capital Gains Tax (CGT) (the engineer who lived in Italy wrote out a mathematical formula for managing his portfolio which we never fathomed out).

There are, of course, good UK products like investment bonds, and stocks and shares ISAs, which can be particularly useful to such clients. But a standard stocks and shares portfolio, outwith an ISA, can also do the trick perfectly well as long as capital gains considerations do not end up cramping its style.

I have already hinted at the variety of both clients and investments but there is no getting away from the fact that there are, for me, really only four mainstream investments for most clients and they are cash or deposits, government or corporate fixed interest (usually bonds or preference shares), equities and property. The variety comes in the wrappers, the way in which the assets are managed, the different business sectors or the geographical spread. The myriad of investments one reads about in the Sunday press tend to be a combination of two or more of these four basic building blocks.

The secret is to try and get into the mind of the client and assess what they are looking for, to guide them if their expectations are unrealistic, and then provide them with a solution that they are comfortable with. Anecdotes are often the best way of getting a message across. For example, on inflation, it is important that they should know that in times of high inflation conventional gilts, especially undated ones like 3.5 per cent War Loan, can be very risky.

In 1974, about two years before Dennis Healey, the Chancellor, had to go cap-in-hand to the IMF for a bail-out, UK inflation was running at over 20 per cent and the price of 3.5 per cent War Loan was quoted at about £19 for £100 nominal of stock. The yield was over 18 per cent (3.5 per cent/0.19). Today after a long period of modest, but quite well controlled, inflation the price is £87.60 for £100 nominal of stock and the yield is just under four per cent. However, with quantitative easing (QE) and the printing of money in the past few years that could change radically.

Similarly, following the massive bail-out of the financial sector and huge rise in government debt, the UK could lose its AAA credit rating. When that happened to the USA and France last year it did not affect their borrowing costs hugely, but it was a different story with Greece, Ireland, Spain, Italy and Portugal at the height of the Eurozone crisis, before the announcement by Mario Draghi of the European Central Bank’s Outright Monetary Transactions programme last year.

It is also useful for clients to know that since 1900 the Barclays Equity/Gilt study indicates that the average annual total real return on a well balanced equity portfolio has been 4.9 per cent. If one looks at the same figure for the period since 1950 it is not dissimilar at 6.3 per cent. At the same time, it is important for clients to know that in any one year there can be a massive movement in stock markets, both up and down. For example the value of the same benchmark portfolio declined by 61.9 per cent in real terms between the end of 1973 and the end of 1974. The market crashed again in 1986, though not as badly, and it also declined by 25 per cent at the time of the Russian default and LTCM hedge fund collapse in 1998 (though it recovered within three months), and then crashed again following the dot com bubble in 2000.

?Complex considerations?

Investment trusts, unit trusts and Open Ended Investment Companies (OEICS) also play an important role in the investment markets. Each kind of fund has its advantages and disadvantages. The share prices of investment trusts which are closed-ended, are quoted on the stock market and are therefore subject to supply and demand. The share price can stand at a discount to net asset value (which can make it attractive) or at a premium (making it more expensive, but generally reflecting previous very good performance, or perhaps an attractive yield). Investment trusts can also borrow and so gear up their performance, both positively, and negatively of course. Total expense ratios and management fees are also worth looking at as they too affect total returns.

It is also important to know what the client’s tax position is. Income tax is the first tax that comes to mind, but CGT can also be a major issue for clients wanting to gift shares or the proceeds of shares, and of course many clients are also concerned about inheritance tax. If so, then one may want to talk about Alternative Investment Market (AIM) shares which qualify for Business Property Relief. However, the nature of such AIM companies (for example, their shares are generally much more volatile), their size and their profitability and whether they are paying dividends or not, also needs to be explained.

Some clients may also want to invest for children and grandchildren and it is useful to know in advance that the tax treatment of bare trusts held for children by parents is different from the tax treatment of bare trusts held for children by non-parents.

On a different tack, for trusts it is important to know that under section 94 4(a) of the Charities and Trustee Investment (Scotland) Act 2005 trustees are expected to take professional investment advice.

The key question, once all these matters have been taken into account, is the allocation of the assets across the four different building blocks already referred to. Then there is the question of the spread across different business sectors of the equity market, and geographically across the globe.

Given that the highly indebted countries in much of the developed world are going to grow more slowly in the foreseeable future than the growing economies in the less developed world, we are inclined to have a reasonable proportion in the stronger, growing economies of the developing world. We also like to have investments which act as a good hedge against inflation should it return with a vengeance. Typically such investments would be index-linked gilts – though they are very expensive at present – and oil and mining stocks. Despite the concern about inflation, we might also live through a period of deflation – as Japan has done for the last decade – and one has to ask the question, therefore, whether one should have a holding in conventional gilts which are a good hedge against deflation.

Finally it is also useful to understand the dynamics of what is happening in businesses and in economies. Sometimes this is difficult if one is not a specialist in the field. For example, understanding exactly what is happening in retail commercial property could be tricky. Different regions of the UK may be subject to differing forces.

In the corporate sector the dynamics of what is happening is often affected by growth in earnings per share (EPS) and is one of the common measures by which chief executives, business managers and investors measure the success of a company. As a result chief executives will tend to return capital to shareholders and increase a business’ borrowing when the business is doing well since this will increase the growth in EPS. However, when the growth subsides chief executives will look to reverse the process and this will tend to weaken the share price.

It is also useful to understand that the same company might be assessed in very different ways depending upon the assessor’s perspective. For example, when I left banking many years ago I would often ask my banking friends informally what they thought of this or that company, particularly if I was concerned about it as an investment.

Frequently I got a very positive response which surprised me until I realised of course that they were speaking as bankers and were only interested in whether they felt that their lending to that company was safe. Frequently they would consider well-established but sluggish companies as excellent.

However, as an investor it is a different story: we look more to the future and as far as investment analysts are concerned sluggish growth does not bode well for the future of a share price.