While most active fund managers measure risk relative to a benchmark, for investors, outperforming a benchmark by 1% or 2% when the value of the market has fallen by 10% offers very little comfort
Savers seeking a safe haven from the volatility and low returns of the world's stock markets should remember one thing: low risk does not mean no risk.
Facing a third year of negative returns, with low inflation and instability looming in the property market, the promise of a steady income return might look very attractive. What every investor should consider is how low the risk profile needs to be before they feel secure and how much prospective upside they are willing to forego to retain that security.
Risk is measured in many different ways. For most active fund managers, it is risk and return relative to the benchmark that matters. For investors, however, outperforming a benchmark by 1% or 2% when the value of the market (and their savings) has fallen by 10% or more offers very little comfort.
In most people's minds, low risk means stability of capital value and a stable income. Some might also express a preference for access to their savings, a degree of liquidity, or some certainty over the prospective investment return. The options available to the low-risk investor are fairly wide-ranging. Each should be considered on its own merits and in the light of the investor's individual tolerance for residual risk.
By shopping around, savers can achieve rates of around 4% on deposit accounts. This compares fairly well with most bank accounts ' the average current account pays less than 0.5% ' but rates can be reduced. Some accounts offer guarantees, promising to link returns to base rate. The value of the promise varies widely, however, from level yields to 3% below the reference rate. If the next move in base rate is up, then savers will benefit directly instead of waiting for their bank or building society to respond.
A variation on this theme is the cash unit trust or Oeic. High-quality cash funds will have an S&P rating and should offer a headline rate close to base. Fund charges range from 0.3% upwards and should be examined closely before placing your money.
As a short-term investment, cash is definitely the most attractive low-risk option. Savers should be aware, however, of the steady erosion in the value of their savings wrought by general price inflation.
Headline returns of 4% are seriously impacted by inflation of 2% to 2.5%, even before the Inland Revenue takes its cut.
The Government issues fixed income securities, currently yielding around 5%, and index-linked gilts. Gilts trade freely and can be bought in the open market. With income and capital guaranteed by the UK government, the investor has a fairly secure return.
The only caveats are that resale values can fall (if the general level of yields in the market increases) and, when the gilts mature, there is no guarantee that you will be able to re-invest the proceeds at the same rate. Those fortunate enough to purchase gilts yielding 12% or more in the early 1990s had a rude awakening when re-investment rates halved in the ensuing years. In recent years, the returns available from gilts have been depressed by heavy demand from UK insurance companies and pension funds.
Corporate bonds are mostly fixed income securities, although there are some index-linked bonds available. Issued by companies rather than governments, they have a higher risk of default, and can be downgraded by rating agencies.
This means that capital values are more volatile than gilts, but yields are higher in compensation.
Good quality, longer dated bonds yield up to 1% more than gilts. Bond funds have the benefit of spreading investor risk across a wider number of individual bonds and companies but they do carry management and custodian charges that reduce the yield.
As with government gilts, bonds trade freely and capital values will vary over time. The biggest risk is that markets become more concerned over the outlook for inflation and interest rates, selling down prices and raising yields.
Fluctuations in capital value can be 5% or more in a bear market for bonds, but, once you take income into account, it is most unusual for total returns to stray into negative territory over any twelve month period. Investors need to be aware that bond funds offering higher yields invest in securities with higher risk of capital volatility, and this can be significant in the shorter term.
Only some national savings products are tax free, but they all share the characteristic of offering a low return. Fixed interest savings certificates, children's bonds and the most popular Premium Bonds. More than 20 million people own the bonds, with around 600,000 winning prizes every month. The capital invested is secure, the prize fund rate of return is an average 2.4%.
This will vary (somewhat indirectly) with movements in base rate and is less likely to be achieved on holdings below £20,000. For most savers, the chance of winning a large amount of money is remote. Nevertheless, the arrival of even small cheques in the post can brighten the day of any investor.
Investing a lump sum for a fixed term (up to five years) in one of these bonds has advantages for basic rate taxpayers. The bonds generally pay income in instalments, although this can be rolled up into the capital return. Investors are essentially locked in to a fixed rate, which may be disadvantageous if base rate is increased. There is a balance of term consideration, which says that rates have to rise significantly (to more than 6%) before the bonds underperform the variable rates available from building societies. Savers should weigh the prospect of locking in to current yields, with the advantages of the enhanced return, before investing in any fixed- term contract.
Moving away from income generating investments, it is still possible to limit investor risk through the purchase of a capital guarantee.
So long as the investor is clear about which market index the bond is linked to, how long the investment is locked in, and how much of the market upside will be delivered, then these investments can offer an attractive alternative to direct equity investments.
The bonds work by placing the money invested in a cash instrument, then using the income generated to purchase options on the market index. The return on the bond will vary with the amount of income generated, the management charges, and the cost of buying the options.
Given the fixed term nature of the investment, savers should again weigh the prospect of locking in to current yields and option pricing, with the possibility that returns might improve if interest rates increase. The key points to consider are the participation rate ' how much of the market upside accrues to the investor, and any qualifications applied to the capital guarantee.
Recently popular as a familiar asset (residential property), with an attractive yield and the prospect of capital gain, the risks of this type of investment should be fully investigated and understood. These arrangements generally involve a substantial initial outlay, in that capital and transaction expenses, and a degree of gearing through mortgage finance.
The recent experience of rising house prices and low or falling interest rates may not be sustained and may not be universally applicable where local supply conditions can affect returns. Rental voids, unexpected maintenance costs and fluctuations in market rents may also impact yields. What looks like a low risk investment may turn out to be anything but.
Another case in point, these funds were marketed as high-yielding investments with a structure that had a reasonable probability of returning capital as well as income to the investor. Sometimes promoted as low risk, many have lost 50% or more of their value in the last year, prompting claims of mis-selling and compensation. The trusts relied on equity markets delivering a positive return, and the structure geared investors into market shortfalls.
Providers relied on equity markets delivering returns around the mean values experienced over the previous twenty years. When markets failed to oblige, delivering negative returns that were firmly wedged in the left-hand tail of the probability distribution, the structure became unstable. They looked too good to be true, and turned out to be too good to be true. Complex structures (often based on theoretical probability distributions of return) do not automatically increase investment risk, but they can obscure it very effectively.
Low risk has historically meant low nominal investment returns. In the context of a low inflation market environment, this is unlikely to change. What has shifted is investor perception of risk in equity markets. Two years (and counting) of negative returns have raised doubts that, on a reasonable time horizon, equities will outperform.
The traditional perspective, that anyone investing on a 12-month view should look first at cash deposits, moving towards fixed income bonds on a three to five year stretch, and equities for the longer term, probably still holds.
For most active fund managers, it is risk and return relative to benchmark that matters.
As a short-term investment, cash is definitely the most attractive low-risk option.
Low-risk has historically meant low nominal returns and this is unlikely to change in a low inflation environment.
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From 1 April 2019
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