Category: Uncategorized

Can investors trust what they don’t understand?

In this video Tim Haywood, chief executive of Augustus Asset Managers argues that investors should place the same level of trust in fund managers as they do in manufacturers of high performance cars. In essence, do not try to understand what goes on under the bonnet.

In general derivative based funds, using options and futures and other complex financial instruments are difficult to understand for most investors and it is arguable that even the fund managers do not exactly know what levels of risk they are entering into. In addition, many tend to be based in offshore locations and lack proper transparency.

Useful Changes to Contracting Out Rules

The government has just introduced new rules which will improve the choices available to millions of pension policy owners. The rule changes, which will come into effect on 1st October 2008, affect those with Protected Rights Benefits. These are acquired when an employee person opts out (known as Contracting Out) of the State Second Pension S2P (previously known as the State Earnings Related Pension Scheme- SERPS).

Protected Rights can be acquired in a number ways:
1. Via a Personal Pension or a Stakeholder pension. Employees pay the full rate of National Insurance Contributions. After the end of each tax year the Revenue work out how much has been paid and rebate a part of this into the employee’s plan (something I am frequently asked about and the subject of a later blog).
2. Via Contracted Out Money Purchase Schemes (known as COMPs). These are employer sponsored pension schemes. The employees pay reduced National Insurance Contributions and the employer makes minimum contributions to the scheme.
3. Via Final Salary Pension Schemes (also known as Defined Benefit Schemes). These are schemes that provide a promised level of benefits to members when they retire, typically based on their final earnings and years of service. Where the scheme has opted out of S2P, these are expressed in the form of a pension but they can be expressed as Protected Rights or converted especially if the benefits have been transferred.
4. On divorce or termination of a Civil Partnership where a Pension Sharing Order is made. In such circumstances the pension benefits of one of the spouses/civil partners is allocated under a Court Order to the other. The benefits can be provided within the same scheme but more typically the scheme will require that they be transferred out.

Successive governments have imposed restrictions on the way in which Protected Rights may be paid out. Quite a few rules have been removed in the last few years and the remainder should disappear all together from 2012. However, for now, benefits must be taken from age 50 (55 after 5th April 2010) and these must include a spouses/dependents benefit. It is also currently a requirement that they only be invested in insured pension arrangements.

On 1st October 2008 the new rules will allow Protected Rights Benefits to be transferred into a Self Invested Personal Pension (SIPP). Until recently these types of schemes were not regulated and as a consequence transfers of Protected Rights into them were prohibited. SIPPs allow investment in a wide range of assets including stocks and shares, investment funds and commercial property. It is also possible to borrow 50% of the value of the assets in the fund to assist with the purchase of new investments, such as buildings.

The ability to invest in commercial buildings is particularly useful to business owners wanting to invest in new premises. SIPPS can even be used to buy the premises already owned by the business, thereby releasing the capital locked up in the building. The proceeds received by the business can be used to help finance expansion, or even to simply pay off accumulated debts.

If the SIPP buys trading premises for the business, the business is required to pay a market rent which is fully relievable against its taxable profits but received tax free by the scheme. As the scheme does not have to pay tax on its rental income all of it can be used to reduce its borrowings. This results in the earlier repayment of the borrowing which means less interest will be paid.

A group of SIPPS owned by different individuals can collectively purchase premises. This is a method used by quite a few professional firms such as lawyers and accountants as well as doctors and dentists.

This is not just an opportunity for new investments but also for top-ups to existing schemes. These can be used to make additional investments. Alternatively the additional funds can be used to reduce scheme borrowings.

As with any transfer of benefits it is important that professional advice is taken from an appropriately qualified independent financial adviser. They will be able to review all of your options for you as well as make sure that you are fully aware of any adverse consequences of transferring your benefits.

Markets are basically efficient

Markets are efficient

My core belief is that markets are “efficient.” The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a share is the consensus of their opinions about the share’s value. Since the price is the same for everyone, so is the value. The price the market strikes is therefore based on all the available information about a share, everything the investors know that has happened in the past and everything they predict will happen in the future. In this sense, markets assemble and evaluate information so effectively that the price of a share is usually our best estimate of its intrinsic value.

Prices are not always perfectly correct, nor is that a condition for market efficiency. The consensus view of investors can temporarily result in prices well above or well below a share’s intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over other participants. Since “mispricings” tend to occur in both directions and since managers seem to over- and under perform with random frequency when adjusted for risk and costs, markets seem to be efficient.

Optimum Portfolio Structure

The optimum portfolio structure is based on, and supported by, a substantial body of academic research into the sources of investment risk and return which has reshaped portfolio theory and greatly improved understanding of the factors that drive performance.

Three Equity Factors

Market: Shares have higher expected returns than fixed interest.
Size: Small company shares have higher expected returns than large company shares.
Price: Lower-priced “value” shares have higher expected returns than higher-priced “growth” shares.

The notion that equities behave differently from fixed interest is widely accepted. Within equities, it has been found that differences in share returns are best explained by company size and price characteristics.

Two Fixed Interest Factors

Maturity: Longer-term instruments are riskier than shorter-term instruments.
Default: Instruments of lower credit quality are riskier than instruments of higher credit quality.

In the realm of fixed interest, two factors drive returns. Though these two factors characterise interest-sensitive investments, they do not have substantially stronger long-term expected returns. Therefore, fixed interest is best kept short in maturity and high in credit quality so risk exposure can be increased in the equity markets, where expected returns are higher.

The Benefits of Diversification

One of the best-established methods of risk management in investing is diversification. The concept is simple: holding only one share in your portfolio makes you directly susceptible to its price changes. If its price plummets, so does your entire portfolio. Hold two shares instead and, unless they both plummet, the portfolio is still afloat. The key to diversification is the age old adage, “don’t put all of your eggs in one basket.”

The main point of diversification is to reduce risk rather than improve expected return. For many European investors, the MSCI Europe Index represents the first equity asset class in a diversified portfolio. Although this index is diversified in European companies, investors can benefit by adding further components. Take, for example, a portfolio that holds just European shares, a portfolio that holds international shares (ex Europe), and a portfolio that holds a third in both regions with a third in international bonds (Citigroup World Government Bond Index Hedged). The diversified portfolio has a substantially lower standard deviation – risk to you or I.

MSCI Europe Index: 18.6%
MSCI World Ex Europe Index: 17.7%
Balanced Portfolio: 11.7%

(Balanced Portfolio is one-third MSCI Europe Index Gross Div., one-third MSCI World ex Europe Index Gross Div., and one-third Citigroup World Government Bond Index 1-30+ Years Hedged. Data in USD.) MSCI data courtesy of Morgan Stanley Capital International.

Citigroup data courtesy of Citigroup Global Markets Inc. Performance data represents past performance and does not predict future performance.

This is the power of diversification: the whole is greater than the sum of its parts

The Importance of Asset Allocation

Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.

I believe investors should not only diversify across securities within an asset class, but also across asset classes themselves. This should include the full range of strategies: small and large stocks, domestic and international, value and core (growth), “emerging countries,” global bonds, and even real estate. Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts. Investors have the ability to achieve greater expected returns with lower standard deviations than they would in a less comprehensive approach.

However, because no two investors are alike, there is no single “optimal” asset allocation. Each investor has his or her own risk tolerances, goals, and circumstances that dictate the weightings in each asset class. In general, the greater the proportion of stocks a portfolio holds, especially small cap and value stocks, the more “aggressive” a taker of risk it is and the greater it’s long-term expected return.

Adding Value

Many investment managers either believe they can actively exploit “mispricings,” so they engage in traditional active management; or they believe they can do nothing to add value over benchmarks, so they engage in traditional index management. I believe in a different approach. This combines the broad diversification, low cost, and reliable asset class exposure of passive strategies and adds value through engineering and trading.

Multifactor Investing

Academic research has shown that the three-factor model on average explains about 96% of the variation of returns among fully diversified professional US investment plans. Investing is therefore largely about deciding the extent your portfolio will participate in each of the three risk factors. In general, the greater the risk exposure, the greater the expected return.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you
Experienced Personal Finance Comments My Ecademy Blogs
Contact me