April 2008

Assessing assets

When considering the range of asset classes available to investors, it is important to decide who the audience is. For the purposes of this piece it is the ordinary investor that concerns us, so I am excluding direct investments in stocks and shares (which require a broker), as well as the more exotic investment opportunities such as foreign exchange (FX) funds, hedge funds and the like. Those asset classes would acceptably be of greater interest to a more sophisticated investor. However, there is more than enough in the mainstream of pooled vehicles to offer the majority of investors choice and diversification. These vehicles, such as pension funds, OEICs (open ended investment companys) or unit trusts, pool investors' money and in doing so provide cost effective access to investments that might not otherwise be available.

Now we come to a major tip for many IFAs and for ordinary investors. Whenever you are considering a more sophisticated investment vehicle, such as a total return fund, it pays to invest in them through an insured fund, rather than direct through a collective vehicle like a unit trust or an OEIC.

The reason for this is that the investor gains an additional layer of security by investing in insured funds, rather than directly. It doesn't mean that the fund won't lose money but it does mean that the investor can be sure that the mainstream strategy remains consistent, or that changes are communicated.

Regardless of the pooled vehicle used, an ordinary investor can access a single asset class, or a managed spread of asset classes.

Now let us look at asset classes directly, most of which will be available through a pooled vehicle. For ordinary investors they break down into the following:

Definitions:

1) Cash: whether held in a Post Office account, a fixed income bond or merely in a bank account, cash has some very clear advantages and disadvantages. It is not obviously "at risk" when held in these ways, your return is a known quantity and you get your principle back unchanged. However, cash is subject to having its value eaten away by inflation over time, and over any reasonable length of time it always performs considerably more poorly than, say equities. This makes holding cash for the longer term, say, 20 years, a risky proposition - a fact that many people do not grasp.

2) Bonds: simply put, these are loans with the borrower guaranteeing to pay a specific return over the period of the loan. Government gilts are loans to a sovereign government, eg. the UK. Investment grade corporate bonds are deemed to be riskier than government gilts, since corporates, no matter how large, are more likely to fail than Governments. So in theory you should get a premium for investing in corporate gilts to compensate for the added risk. In practice, in recent years, this "premium" shrank to the point where it was almost non existent. This encouraged many investors to look at bonds issued by companies higher up the risk curve (i.e. smaller companies who, by virtue of their size, are more likely to fail to be able to repay their debt). Known as high yield bonds, the companies offering those bonds have to pay more interest to compensate the investor for the increased risk. When the economy is booming, many investors will happily invest substantially in "high risk" corporate bonds. However, as soon as the economy worsens, there is always a rapid flight out of high yield corporate bonds, and unless selling investors move fast, it can be hard to find any buyers. This can leave the investor trapped in a bond market that is losing value rapidly.

3) Equities: all equities, which is to say, investments in quoted company shares - are "at the mercy" of market movements, and can chase up and down as the world's stock markets rise and fall. However, over a 20 year time horizon, history shows that equities are a low risk asset class. They show a rise in value of around 6-7% per annum over the longer term. The range of equities are however broad, and that's where the subdivisions play their part. While related, each will deliver more or less in different economic conditions.

4) Property: a) Residential (bricks and mortar): the form of property investment that most investors will be completely familiar with is the investment in their own home, or in a second, or buy-to-let property. For some investors this is becoming popular either as an alternative to long term pension investment or as an adjunct to pension investment. Residential property, as a direct investment can be risky - the costs are high, buying and selling takes longer than for other asset types, and there are few traders when compared with other asset classes. While "bricks and mortar" tend to be a low risk investment, taken over say two decades or more, property is a cyclical investment and volatility in property markets can catch investors out badly.

b) Commercial property: investments here can be either directly in bricks and mortar or through property securities. Bricks and mortar investment tends to be low risk over the longer term and valuations tend not to fluctuate greatly, albeit that is largely due to subjective valuations. However, property is a cyclical investment and volatility can catch investors out badly. The disadvantage of a "bricks and mortar" investment is that they can be hard to get out of, or to cash in. Property securities and other forms of indirect property investment have tended to provide property like returns over the longer term, but will experience equity volatility in the shorter-term. This means that commercial property funds can be very volatile. Commercial property is coming off a five year bull run, where returns have been spectacular though the prognosis made by many market watchers is that this rate of return will fall to "normal" levels for the next few years, and will probably underperform equities.

Mark Pearson
Head of Investment Strategy and Communications
AEGON Scottish Equitable