“Return Free Risk” – How Trustees Can Deal With This New Reality
People used to talk about the “risk free return” but recent economic events have spawned a new phrase to capture the essence of current investment offerings “return free risk”.
It may be a joke, but it reflects the new investment reality.
This is the first article of a series about how trustees can deal with this new reality, by focusing on the benefits the trust is intended to provide.
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It is worth looking at returns on low risk investments, in the context of inflationary expectations of 3% over the next 12 months.
- Deposit accounts yield 2% at best, which is not good if inflation is 3% and it is even worse if the interest is taxed.
- As at March 2013 short Gilts only yield about ½% pa and yields only reach 3% for Gilts maturing in 2034. The capital guarantee only applies at maturity. If yields rise market values can fall substantially in the interim.
- Index-Linked Gilts guarantee to maintain income and capital in real terms but the investment returns are also negative in real terms, offering a real loss of up to 2¾% pa. Otherwise the risks are similar to those of conventional Gilts.
In order to obtain a reasonable return, any investor is forced to take some kind of risk. Trustees need to consider the trusts ability to accept those risks in the context of the benefits it is there to provide. It is therefore worth examining the various aspects of risk in more detail :-
- Capital Risk: The risk that the investment might fall in value.
- Income Risk: The risk that the income from the investment might fall in value.
- Marketability Risk: The risk that the investment might prove difficult or impossible to realise when the capital is needed.
- Divisibility Risk: The risk that in order to meet a small, but necessary, item of expenditure, the whole asset has to be realised.
To the extent that trustees can compromise on any of the above, they can improve their investment returns.
Marketability and divisibility are not necessarily risks in the conventional sense and, in any event, trustees have a portfolio of investments. The whole portfolio does not have to be particularly marketable or easily divisible. The portfolio just has to be sufficiently marketable and sufficiently divisible to meet the trustees’expected and contingent needs.
To the extent that cash flows are predictable, term deposits and short-term Corporate or Government bonds become an option, particularly if, in an emergency, the trustees have the ability to borrow to cover a temporary shortfall.
It may be mundane, but management of the fund is a cash flow problem, and if cash does not flow when it is needed, there is something wrong with the investment policy. On the other hand compromising on marketability or divisibility, for some of the fund, is a low risk way of enhancing investment returns.
The main point of this series of articles is that the key objective of any investment strategy is to provide the benefits for the beneficiaries of the trust. If that central objective is forgotten, maximising investment returns or minimising tax liabilities may become counterproductive.
Balancing the needs for capital and income growth with the associated capital and income risks is to be the subject of a subsequent article.
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