The proposed reforms to pension law offer a once-in-a-lifetime opportunity to investors and IFAs alike, provided that both avoid the mistakes of recent decades, which have made so many current schemes worse than useless.
Accepting reality
The key lesson is that there are no answers to the problems of investing. Even though few professional investors still believe in the efficient-market hypothesis, they stick to it for want of a better over-arching theory, which will both explain their failure, and extract rents from their unfortunate clients. There is no such theory, nor will there ever be; the world itself, its economy, and even tomorrow are all too diverse and too dense to be understood except imperfectly.
Investors have one duty, and that is to use their capital – or regular savings – to buy an income for themselves and their family at the cheapest possible cost. In doing this, investors are similar to quoted companies; both must be aware of their internal cost of capital, since failure to do so results either in a Tesco at a corporate level, or pauperism in private life.
That income must also grow, since our retirement lives are now almost as long as our working careers, and the bond markets have become dangerously unstable through the activities of central banks, and the derivative machinations of the investment banks. So the classic 60:40 equity:bond split is now dangerous. The next financial crisis may well see actual defaults on some of the credit – and even bond – issues that have been geared up through derivatives in enhancing their appeal to yield-hungry investors.
Declining economies
Even before the 2008 banking crash, western economies were doing badly due to growing political sclerosis and the ill-judged 1990s banking deregulation. This underperformance is continuing. Economic mis-diagnosis is easy, especially when better answers are combined with the necessity of unattractive political solutions. The welfare model designed and erected in the years after 1945 can no longer be justified with current tax levels.
“We all know what to do, but we don’t know how to get re-elected once we have done it,” said Jean-Claude Juncker, former prime minister of Luxembourg and current president of the European Commission, during the financial crisis. Investors must hope that his honesty and proposed restructuring of the Brussels bureaucracy will encourage his former colleagues of the Council of Ministers to begin the necessary supply-side changes within European economies.
Back to the future
Some IFAs had already discovered, well before the RDR, that investment trusts offer quality investment management at a very modest price – a reflection of a corporate structure that allows good process to support long-term investment strategy. This remains true, although many of the newer trusts – especially those utilising the tax benefits available to investors in private equity – have philosophies that have strayed far from the values of those originals.
But a corporate structure enables mangers to put aside reserves when times are good, and to have money for dividends when economies turn. Table 1 shows the Association of Investment Companies’ (AIC) current list of dividend heroes – those 16 companies that have increased their dividend every year for at least the past 20 years.
On the face of it, none seem particularly attractive investments, with little rhyme or reason as to why some should be selling at a discount to asset value [marked in the Table] and others at a premium. More importantly, with current yields ranging from less than 1 per cent to 4 per cent, none can cover the investors’ cost of capital.
For virtually every one of us this is made up of inflation, which averaged 2 per cent pa over the 14 years of the Table plus the ongoing investment management charge with or without its performance fee. With the RDR, most performance fees have been dropped since there is neither justification for such a fee on top of ordinary management charges, nor evidence that these serve to motivate managers to do better than average.
The total expense ratio (TER) of the different trusts is shown in the Table but it excludes stamp duty, bid-offer differentials and other dealing costs. So despite the increasing dividends, these companies are not meeting our cost of capital, let alone making money for us. Moreover these are just our basic costs; add in platform fees, and IFA charges for investment and savings advice – and then each and every dividend hero leaves us underwater.
Thinking long term
Table 2 shows it more favourably, however much it might fly in the face of the mantra that past performance is no guide to the future. These are the same 16 companies, showing the number of years of dividend performance, but also the increase in value of £100 over the period, and what this is in terms of an annualised gross return.
At this level, at least half of the trusts are definitely making money for us – the other half, although doing relatively well in comparison to their unit trust competitors, are not finding the investments that exceed their own cost of capital. As an example of market (in)-efficiency, the best return of all 16 trusts can be had at a 15 per cent discount to net asset value, for Caledonia is regarded as illiquid. This trust is the transmogrified family fortune of the Cayzer shipping family, and good at buying into similar European family businesses, as well as private equity.
With a 40-year accumulation period, and 30-year spending time, the average pension fund investor need not be worried about year-to-year liquidity of any investment trust, except as a guide to what and when to buy and sell. This is the time for accumulators to be buying not only Caledonia but also Value & Income, while spenders could be looking at the premiums on Temple Bar and City of London as a good sign to sell and raise living expenses.
The nature of all investment trusts can be examined either through the AIC website or that of Numis Securities. Common sense is the tool to use in identifying the independence of the board, and the interaction of board and manager, in the development of an investment strategy, and the courage and competence of the manager in turning this into a successful portfolio.
Choosing the right investment trust for each individual is again common sense – some need to give global exposure, others to concentrate on income, but all need to be aware of the threats to current profitability offered by rapidly changing technology. My March 2014 investment spotlight showed how two similarly performing trusts – Personal Assets and Scottish Mortgage – had very different risk/reward profiles.
A little bit pregnant…
A portfolio of half a dozen investment trusts should see the average investor through their working life, and leave them comfortably off for a long retirement. But confirmation that all is going well needs regular recourse to both websites and common sense, for we all need to remember that our governments are conducting an interesting experiment on our behalf.
Since 1900 annual inflation in the UK was 4 per cent a year, although over the 14 years of the table it has been 2 per cent. The failure of political courage has seen Europe falling into Japan’s 20-year deflation.
So for the first time since the end of the gold standard in 1931, all major central banks – at the behest of their political masters – are attempting not to control inflation but to encourage it. So will it be possible to be just a little bit pregnant? Don’t bet on it.
