As the world entered the new millennium, we were all braced for the Y2K problem.
Aside from the well-touted problems with many split capital investment trusts, traditional with profits contracts have had their flaws exposed. We saw that during the previous decade, investors build their portfolios around a core of with-profit bonds in the belief that they would produce steady incremental returns over time. However, the collapse in equities has caused with-profit bonds to slash annual and terminal bonuses and raise exit penalties (via MVRs) to protect remaining reserves. These problems have been made even more painful as it is exactly in conditions such as these that these investors were counting on smoothing to protect them from the worst of market falls.
So why did it go wrong?
First of all, let us acknowledge that, conceptually, with-profits met client needs perfectly. The product promised that annual bonuses would compound returns with the potential of an additional windfall on maturity from the granting of a terminal bonus – steady returns with upside potential. They seemed to offer little risk and advertised high headline rates of returns to tempt investors. The problem was not the promise but the reality. It is now clear that the high headline rates of return, the history of significant terminal bonuses and smoothed returns were difficult, if not impossible, to repeat. Early gains were provided by the magic combination of rising equity markets and relatively small numbers of policyholders. Strong equity performance meant fund returns were greater than promised, creating a pool of assets that funded better than expected returns, paid via higher terminal bonus levels. That meant, like most things in life, the early investors did disproportionately well and, as the crowd arrived, the potential for excess returns eroded.
Smoothing has proven particularly difficult in this bear phase. Free Asset ratios (a measure of the fund's net asset position and ability to pay terminal bonuses) of the key market participants need to be rebuilt after three years of equity bear markets. That will restrict potential returns to investors over the coming years. Many funds are skewed heavily toward fixed interest, more because of with-profit providers' need to maintain solvency ratios rather independent investment rationale.
So what should clients do?
The theory – construct well-balanced portfolios tailored to protect and enhance wealth – remains sound, but may be better provided by a new generation of products. The Sandler report has suggested a suite of potential successors to with-profits, including a mutual fund product with a minimum weighting in bonds and equities and cautious characteristics. Following Sandler's report, the Treasury proposed the Cautious Managed fund as the champion of the 'cautious' product suite, supported by the Investment Managers Association. Funds with the 'cautious' tag limit the magnitude of equity exposure managers are allowed to take to 60%, which provides a good compromise between more aggressive balanced managed funds and defensive managed funds. They aim to deliver smoothed returns by blending bonds and equities, which tend to be negatively correlated. Able to function as a core mutual fund product, straightforward and offering diversification, these funds meet Sandler's recommendation.
A Cautious Managed fund is thus a transparent product that offers the diversification that most investors seek. The right manager can provide active bond and equity management and, crucially, asset allocation that fits market conditions. Bear markets have punished complex products that have too many working parts. Simple products, flexible enough to function even in tough conditions are likely to offer better long-term rewards and should form the core of an investor's portfolio.
Andrew Sowerby is joint managing director, Investec Fund Managers Limited www.investecfunds.co.ukIFAonline
