Investment instruments that have no prospect of paying an income, such as gold, are speculative. The value of the asset is entirely reliant on finding a counterparty to a trade. A speculator might own all the gold in the world, but it is worthless if he cannot find a buyer.
While there is place for speculation at the fringes of an investment portfolio, we don't believe that speculative instruments should play a major role; our advisers concentrate on cash, bonds and equities.
This table shows what an investment of £100,000 in different asset classes would have achieved over the past 25 years:
In order to get the best possible equity market return, we focus on exposing our clients to the dimensions of higher expected return that various academics have identified, notably Professor Eugene Fama, of the University of Chicago Booth School of Business, and Professor Kenneth French, of the Tuck School of Business, Dartmouth College.
Fama and French's research suggests that smaller and low-priced companies (i.e. companies whose book value of assets is high relative to their market price) perform better than the market average over time.
Because risk and return are related, the higher expected return comes at a price and, as a consequence, investing in these companies is riskier than investing in the whole market. There are periods when these groups of shares underperform the market, but research indicates that these risk premiums have been worth paying over time.
The chart below shows how these risk premiums have rewarded investors in comparison to an investment in the whole market in different countries. Based on this, we tilt our clients’ portfolios towards small and low-priced companies to an extent that is appropriate to the investor and their long-term goals.
This graph shows the higher expected returns offered by small cap stocks and value stocks in the UK, Europe, US and emerging markets:
Research also indicates that fixed income, or bond investments, exhibit two risk premiums: Duration and credit-worthiness of the bond issuer.
In principle, longer term bonds and those issued by companies with a lower credit rating are more risky, but pay a higher yield. The portfolio construction section explains how we use fixed income in our portfolios.
While property certainly qualifies as a "natural" asset class, we use it sparingly in our clients' portfolios for the following reasons:
It is a difficult asset class to capture passively.
Although real estate investment trust funds are available as collective investments - mostly as exchange-traded funds - their structure can be unsuitable for regular premium investors.
Unlike equity and bond market indices, which are updated based on the daily movement of prices in the market, property indices such as the Investment Property Databank index are only updated quarterly. As a result, it cannot be said that the asset price is derived from an efficient market process.
Actively managed funds invested directly into property are not always liquid. This can restrict an investor’s ability to redeem funds when asset values are adversely affected by market conditions.
While not directly related to the dynamics of portfolio construction, many investors already have significant exposure to property in their overall net worth.
Hedge funds, absolute return funds and structured products
We regard the returns generated by hedge funds and other esoteric and opaque strategies to be synthetic. That is to say, fabricated from the natural components of capital markets, but modified with borrowing or derivatives to produce a different type of return.
These are strategies, not asset classes, and are more complex, expensive and less liquid than traditional funds. We only use hedge funds or absolute return funds where we believe that market distortions require their use to reduce portfolio volatility. Where possible, they will not form a long-term aspect of our portfolios.
Alternative investments in the form of art, antiques, fine wine and even hard commodities, such as gold, should always be considered as part of the investor’s portfolio. However, we feel that this area of investment should be considered by an expert in the field.
While we always consider this when analysing an investment position and portfolio, our expertise lies predominantly within the more traditional areas of investment management.