Experts warn of ‘broken’ risk and reward relationship

Experts warn of ‘broken’ risk and reward relationship

At the prospect of a post-Brexit base rate cut to boost confidence, advisers are having increasingly difficult client meetings to manage return expectations, with some questioning if the term ‘risky asset’ has now become redundant.

On 14 July, the Bank of England’s Monetary Policy Committee kept the base rate at 0.5 per cent, defying expectations after governor Mark Carney hinted at possible changes to the base rate over the summer, leading many to suspect the rate will now be announced on 4 August.

But wealth managers have expressed concern the central bank is encouraging investors to invest in riskier assets in a bid to get better returns.

Andrew Wilson, head of investment at Towry, said some funds are either gambling with capital to try to meet expectations which are too high, or others – such as pension funds – have set an expected level of return which they cannot meet because their mandate does not allow them to have the asset mix.

Some pension funds are still pledging a return of 7.5 per cent, he said, which he pointed to as demonstrating many in the institutional space just have not come to terms with the lower rate environment.

“A few years ago, if you were a cautious client, you could justify going up the risk curve, but more recently moving up the risk scale is now a very risky thing to do,” stated Mr Wilson, arguing that rather than looking at risky assets, it was more appropriate to think of a risky time horizon, now clients are advised to consider investing for at least 10 years.

“Clients are generally aware of low interest rates and low inflation, but haven’t always linked that up to lower potential investment returns.”

Peter Lowman, chief investment officer at Investment Quorum, said the question of what constitutes a risky asset has become “toxic”.

He said: “I suppose you could say cash is a risky investment over the long-term, given that it is failing to beat inflation and is unlikely to do so for the foreseeable future, as interest rates are expected to be cut further over the coming months.”

This is why 10 and 30 year UK gilts offering an “insignificant” yield of 0.76 and 1.65 per cent respectively still seems an attractive option compared to cash, noted Mr Lowman, or the “better option” is the 3.72 per cent yield on offer through the FTSE 100 index; although this equity classification means it would be deemed as risky.

The emergence of 0 per cent interest rates - which the UK could see at the next meeting of the monetary policy committee - is an “unfortunate consequence” of past mistakes in the financial system, he added.

“Clients have therefore needed to be informed about these consequences, which has in some cases made for difficult conversations.”

Most members of the Bank of England’s MPC have voted to maintain rates at 0.5 per cent - a seven year record - although one member has been pushing for a rise: Gertjan Vlieghe (see graphic).