The Small Print

The contents of these muses are my own opinions, should not be taken as a personal recommendation to invest in the areas mentioned and does not replace the need for individual independent advice.

Answers to Quiz

The correct answers shown in red, the wrong answers are in plain text, comments are in green and the marking system is in blue.

1. What is a gilt?

An easy one to start.

(a) a corporate bond

(b) a government bond

(c) a type of gold

(d) the expression on your dog’s face when it pinches food off the kitchen table.

Marks:           One point for the correct answer.

2. Place in order the following economies from highest to lowest in respect of the percentages of their GDP (gross domestic product, a measure of their economic output) that are imports and exports.

UK, US, Eurozone and China.

Eurozone, UK, China and US.

The Eurozone has the highest dependency on exports and imports and the US the least. The US economy is very domestically focused and consumer oriented.

Marks:           Two points for the exact correct order.

3. Your portfolio rises in value from £159,320 to £197,500. What is the percentage rise to two decimal points?

The answer is 23.96% to two decimal places. The workings are as follows:

First deduct the end value from the starting value, £197,500 – £159,320 = £38,180. That is the gain in cash terms.

To calculate the percentage gain, you need to express the cash gain as a percentage of the starting value i.e. 

       £38,180

      ———–    x 100% = 23.96%.

      £159,320          

Marks:           One point for the correct answer.

4. Which of the following statements about investment trusts are true? There may be more than one.

(a) They are open ended meaning the fund manager can create and redeem shares 

ITs are closed end funds with a limited number of shares in issue. Unit trusts and OEICs are open ended. The closed end structure of investment trusts means the value of the underlying assets per share may trade at a discount or premium to the share price.                                                                                                                                      T

(b) They can borrow to invest

Unlike unit trusts and OEICs. Borrowing to invest means ITs magnify returns and losses.

(c) Their shares are listed and traded on a stock exchange

This is exactly the same as for companies such as BP, HSBC and Diageo.

(d) They are required to distribute all income to investors as it arises

No. They can retain 15% for distribution at a later stage. This enables investment trusts to smooth distributions or increase dividends year on year.

(e) They are good for holding illiquid assets.

This is a feature of closed end funds. Assets do not have to be sold to meet investor demand to sell out unlike with OEICs and unit trusts.

Marks:           One point for each correct answer, maximum  of three. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

5. Which of the following are considered safe haven assets during periods of economic and market stress? Again there may be more than one.

(a) Swiss Franc

(b) Gold

(c) Bitcoin

(d) Japanese Yen

(e) High yield corporate bonds

(f) Shares in travel companies and airlines

(g) US Treasuries.

Marks:           One point for each correct answer, maximum  of four. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

6. Which statements are generally true if Sterling falls in value against other developed market currencies such as the dollar, yen and Euro.

(a) The UK imports inflation

(b) UK exporters benefit in selling goods and services abroad

(c) Foreign holidays are cheaper for Brits

(d) Petrol prices are likely to fall

(e) The FTSE 100 index is likely to rise.                                    

Overseas earnings made in foreign currencies are boosted when repatriated to Sterling. Around 70% of FTSE 100 companies’ earnings are from overseas.

Marks:           One point for each correct answer, maximum  of three. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

7. Which of the following statements about smaller companies are generally true?

(a) They are more likely to suffer more during recessions and economic downturns than larger companies

(b) In the long term smaller companies outperform larger companies

(c) Smaller companies do not pay dividends

Whilst some do not, notably in the early stage when a company is not in profit, many listed smaller companies do pay dividends.

(d) Smaller companies are primarily exposed to the domestic, consumer economy

(e) Smaller companies funds are best managed passively using index tracking strategies.                         

Active fund management is best due to the lack of analyst research and price anomalies.

Marks:           One point for each correct answer, maximum  of three. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

8. Which of the following are normally positively correlated?

(a) Inflation and interest rates

(b) Interest rates and corporate bond prices     

When interest rates rise, bond prices fall

(c) Equities and bonds                                                                                         

A tricky one, sometimes they are, sometimes they are not, depending on market conditions. Overall though a positive correlation cannot be claimed.

(d) Unemployment and wage growth                                                            

They are negatively correlated.

(e) The win ratio of Barnsley football club and the UK economy.           

However if the UK economy improves with falling unemployment and wage growth attendances at football matches might go up.

Marks:           One point for the correct answer. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

9. Place in order the following equity markets in terms of the least to most expensive based on forward price to earnings ratios at 30/9/19

UK, US, Europe (ex-UK), Emerging Markets and Japan.

Emerging Markets, UK, Japan, Europe (ex-UK), US

Marks:           Two points for the exact correct order.

10. An individual has earned income of £18,000 in 2019/20. How much tax will he pay on £17,000 of dividends he receives from non-ISA investments in that tax year?

The answer is £1,125.

In 2019/20 the individual has a £2,000 dividend tax allowance. All of his personal allowance of £12,500 is used up by his salary and he is a basic rate taxpayer. This means £15,000 of dividends are taxable at 7.5% i.e. £15,000 x 0.075 = £1,125.

Marks:           Two points for the correct answer.

11. Someone invested £20,000 in a fund outside an ISA on 1/10/17. Two years later the investment is worth £27,000. The investor sells £6,000. How much is the realised capital gain for tax purposes?

The answer is £1,555.56.

The £6,000 sold has to be apportioned between a disposal of original investment and realised gain. The amount of original capital in the £6,000  is calculated as a proportion

£20,000

———           X          £6,000 = £4,444.44. 

£27,000

The gain is £6,000 – £4,444.44 = £1,555.56.

The calculation assumes for simplicity there is no dividend re-investment.

Marks: Two points for the correct answer.

12. Which of the following investments always pay returns free of income and/or capital gains tax to investors?

(a) Stocks and shares ISAs

(b) Premium Bonds

(c)  Unit Trusts

(d) Venture Capital Trusts

(e) Structured Products

(f) NS&I Income Bonds.

Marks:           One point for each correct answer, maximum  of three. Deduct half a point for each wrong answer but your overall score for the question cannot be less than zero.

There are a maximum of 27 marks.

0-5                  Brushing up required

5-10               Could do better

10-15             Pretty good

15-20             Good

20-26             Excellent

27                   You could be a very good financial adviser

Nothing in this test is intended as personal advice or a financial recommendation, for example to invest in safe haven assets and tax free investments.

Woodford Equity Income Fund

It has been announced today that the Woodford Equity Income fund will be wound up. Previously the intention was to re-open the fund once illiquid unquoted stocks were sold but this is now considered not to be in investors’ best interests. The decision was made by Link Fund Solutions Ltd, the Authorised Corporate Director (ACD) of the fund not Woodford Investment Management. An ACD is an authorised firm which administers a fund’s investments, handles the purchase and redemption of shares in fund and ensures the assets of fund are properly valued. They have the power to sack a fund manager and unfortunately for Neil Woodford this has now happened with immediate effect. The fund will be renamed the LF Equity Income.

The winding up of the fund will commence on 17th January 2020 and it will be undertaken in an orderly manner to avoid a fire sale of assets and investor detriment. A number of capital distributions is intended with the first expected at the end of January. What investors will get back will naturally depend on stock market conditions and the costs the winding up process will incur. For example Blackrock has been appointed to sell listed securities and naturally there will be fees.

It is likely that most investors will lose money on their investment and naturally I am sorry for clients that I recommended the fund to. The only consolation is that investors who bought Woodford’s funds when he was at Invesco enjoyed excellent returns over many years. This makes the extent of Woodford’s fall quite incredible and sobering for IFAs like myself who believe in active fund management. The industry and the regulators will be looking to see if the problems with Woodford are more widespread and will try to ensure there is no repeat or systemic risk for investors.

More information about the decision to wind up the Woodford Equity Income fund can be found in the article from Link Fund Solutions Ltd:

https://woodford.linkfundsolutions.co.uk/media/yr2dbqm2/15th-october-2019-investor-letter-regarding-the-winding-up-of-the-lf-woodford-equity-income-fund.pdf

Have you been paying attention?

For something different to my normal blog posts, here are twelve questions about investments. Have a go and test your knowledge but don’t worry about your score. Hopefully it will be just a bit of fun and you’ll learn a thing or two. See if you can answer the questions from your own knowledge or alternatively make best guesses. There are no prizes. The answers will be published early next week. 

1. What is a gilt?

An easy one to start.

(a) a corporate bond

(b) a UK government bond

(c) a type of gold

(d) the expression on your dog’s face when it pinches food off the kitchen table.

2. Place in order the following economies from highest to lowest in respect of the percentages of their GDP (gross domestic product, a measure of their economic output) that are imports and exports.

UK, US, Eurozone and China.

3. Your portfolio rises in value from £159,320 to £197,500. What is the percentage rise to two decimal points?

4. Which of the following statements about investment trusts are true? There may be more than one.

(a) They are open ended meaning the fund manager can create and redeem shares

(b) They can borrow to invest

(c) Their shares are listed and traded on a stock exchange

(d) They are required to distribute all income to investors as it arises

(e) They are good for holding illiquid assets.

5. Which of the following are considered safe haven assets during periods of economic and market stress? Again there may be more than one.

(a) Swiss Franc

(b) Gold

(c) Bitcoin

(d) Japanese Yen

(e) High yield corporate bonds

(f) Shares in travel companies and airlines

(g) US Treasuries.

6. Which statements are generally true if Sterling falls in value against other developed market currencies such as the dollar, yen and Euro.

(a) The UK imports inflation

(b) UK exporters benefit in selling goods and services abroad

(c) Foreign holidays are cheaper for Brits

(d) Petrol prices are likely to fall

(e) The FTSE 100 index is likely to rise.

7. Which of the following statements about smaller companies are generally true?

(a) They are more likely to suffer more during recessions and economic downturns than larger companies

(b) In the long term smaller companies outperform larger companies

(c) Smaller companies don’t pay dividends

(d) Smaller companies are primarily exposed to the domestic, consumer economy

(e) Smaller companies funds are best managed passively using index tracking strategies.

8. Which of the following are normally positively correlated?

(a) Inflation and interest rates

(b) Interest rates and corporate bond prices

(c) Equities and bonds

(d) Unemployment and wage growth

(e) The win ratio of Barnsley football club and the UK economy.

9. Place in order the following equity markets in terms of the least to most expensive based on forward price to earnings ratios at 30/9/19

UK, US, Europe (ex-UK), Emerging Markets and Japan.

10. An individual has earned income of £18,000 in 2019/20. How much tax will he pay on £17,000 of dividends he receives from non-ISA investments in that tax year?

11. Someone invested £20,000 in a fund outside an ISA on 1/10/17. Two years later the investment is worth £27,000. The investor sells £6,000. How much is the realised capital gain for tax purposes?

12. Which of the following investments always pay returns free of income and/or capital gains tax to investors?

(a) Stocks and shares ISAs

(b) Premium Bonds

(c)  Unit Trusts

(d) Venture Capital Trusts

(e) Structured Products

(f) NS&I Income Bonds.

Nothing in this test is intended as personal advice or a financial recommendation.

Sustainable Investment

Earlier this week I listened to an interesting webinar on sustainable investment given by Mike Fox of Royal London Asset Management (RLAM). It is a term you may have heard or something similar called ESG – environment, social and governance. Nowadays investment companies talk about embedding sustainability or ESG into their investment decisions and similarly businesses are keen to promote their socially responsible corporate culture and practices. For example Diageo, a global drinks manufacturer state the three priorities underpinning their sustainability and responsibility strategy are promoting positive drinking, building thriving communities and reducing their environmental impact. All very well and good perhaps, but what is the difference between ethical investment and sustainable investment or ESG?

To answer this question we need to consider the range of responsible investment strategies and look at the evolution of ESG. For many years most fund managers and many people considered investment to be amoral. Investments were bought purely for their ability to make money. There was no ethical or socially responsible considerations taken into account when selecting what companies or funds to invest in. It is a do nothing approach with respect to sustainability, with everything being a potential investment. At the other end of the scale is philanthropy, with wealthy people giving away money for social good. Here in contrast to an amoral view of investment, social good is the only thing that matters and a financial return is not expected.

In between these two outliers we have ethical investment and sustainable investment, though they are not the same. Although ethical investment came to the market in the mid-1980s, it remained for a long time a niche product with relatively low uptake. It focuses on avoiding the bad using negative screens. Traditional ethical funds are sometimes described as being “dark green.” According to Fox it is dour and focuses on UK and single assets. In contrast sustainable investment which evolved from ethical investment is modern and inclusive with a focus on doing good, rather than avoiding the bad. It is not country or asset class restricted. Fox also asserted that it has led to enhanced returns. Sustainable investment or ESG has now gone mainstream in the investment and corporate world at least. It is all the rage, whilst ethical investment rarely gets a mention.

Fox argues sustainable investment is predicated on the belief that capital can be deployed as a force for good. It is about investing in products and services that are cleaner and healthier and make a positive contribution to society. It is also about good corporate behaviour (ESG). Crucially Fox recognises the importance of making money i.e. generating returns ahead of the cost of capital. In simple terms for each £1 you invest you expect to get more than £1 back. That is what any investor expects. He contrasts this with what is called “impact” investing where below market returns are accepted for a greater social impact. RLAM are not in this arena. They are pragmatists and clearly want to make money for their investors and it is true their range of sustainable funds has been successful delivering strong returns. You won’t find anyone wearing sandals at their offices.

I can see the argument for a more inclusive sustainable investment strategy. Fox cited two examples in his presentation. The first was Diageo which according to Fox is an ESG leader with impeccable credentials, for example on good water management. He takes the view that alcohol itself is socially neutral in nature. It is not inherently bad and is good if used responsibly. In contrast tobacco he observed is socially damaging and harmful and shouldn’t be included in sustainable funds.

The second company was Google which although has had reported ethical issues such as privacy and alleged tax avoidance it has democratised knowledge, made it freely available with a big positive impact globally. Sustainable investment appears to be about making a net positive contribution and for Fox Google and Diageo fit the bill.

So what is my assessment? It is clear that sustainable investment has widened the scope and potentially the appeal of traditional ethical investing. It is undoubtedly increased the investment universe for fund managers in this space, with the potential for greater returns. Fox however did not present any evidence to support his claim that investment returns have been enhanced by a sustainable investment style. Whilst I am aware of some modern sustainable funds have cracking track records I am also aware of dark green ethical funds with terrific performance. So for me the jury’s out. My biggest concern however is that Fox who is clearly a cheerleader for sustainable investment does not appear to see a role for traditional ethical investment and in my experience this won’t do. A good number of my clients are still keen to avoid investment in the so called sin stocks such as tobacco or arms production. They want to invest with a clear conscience and that requires negative screening. For one client all companies involved in animal testing have to be avoided at all costs even if the testing is for human medicine.

The other issue for me, and this is just my personal opinion, sustainable investment or ESG appears to be a classic fad. It has come out of nowhere to the point it seems to be the most important issue in investment, the must have corporate policy to go alongside those on privacy, modern slavery, inclusiveness and diversity. Every business is keen to stress how seriously they take corporate responsibility and the environment. Whilst I am not saying these things are unimportant I can’t help thinking there is a certain amount of virtue signalling going on here. No business wants to be seen lacking in keeping pace with the accepted norms of  social responsibility. Moreover I don’t think the development of sustainable investment was driven by investor demand. It appears to something invented by those who want to make ethical investment less restrictive and therefore more mainstream. I may be cynical but it appears in part to be a bit of good marketing, designed to attract new investors, people who like the idea their investment is a force for social good, even if they are not too concerned about the lack of negative screens. Remember a company that is rejected by an ethical fund may be included in a sustainable fund if it is net positive i.e. its social good outweighs the bad. Finally I am not a fan of the term sustainable. It seems to me that if something is slapped with the label sustainable or progressive, it is indisputably good even before it is subject to critical analysis. That can’t be a good thing after all sustainable itself is not a quality; it is assessment of durability. It can be bad. My quirky sense of humour takes my mind to dictators and despots who pass laws that keep them in power for life. I know it is hyperbole but that is a sustainable outcome!

Despite the rise of ethical and sustainable investment most of my clients do not require it. They make no moral choices on what they are happy to invest in. A minority do. If you are in this camp you will need to decide whether there are strict red lines you don’t want to cross, in which case traditional ethical investment with negative screens is required. If however you are keen for your money to have a general positive social and environmental impact and you are happy to include investment in companies who may have ethical issues but where the good outweighs the bad, then sustainable investment is for you.  

The content of this blog is based on my own understanding of ethical and sustainable investment. It reflects my personal views and is intended as general investment information only.  Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances.

Postscript: Brexit – Outlook for the economy

The day after I published my last blog post about a no deal Brexit, Mark Carney, the Governor of the Bank of England surprisingly announced a revision to the Bank’s assessment of the negative impact on the UK economy. For example GDP contraction was now expected to be 5.5% rather than the previous 8% forecast for the “disorderly” scenario. The impact on food prices would also be less severe. He told the Treasury Select Committee on Wednesday that the reason for the revision was down to no deal preparations by the Government. You can read more in this BBC news article:

https://www.bbc.co.uk/news/business-49585799?intlink_from_url=https://www.bbc.co.uk/news/topics/cw506d1n5m1t/mark-carney&link_location=live-reporting-story .

Carney is not saying a no deal Brexit will not be bad, just that it will be less damaging than forecast in November.

In addition on the same day I listened to a short video clip from Bloomberg featuring the Chief Economist of Deutsche Bank in which he said a no deal Brexit would not mean the end of the world. Although there would be some short term pain the long term prospects for the UK economy would be fine. It is less than two minutes long and well worth listening to.

His views accord with my own. Any investment focussed IFA will distinguish between the prospects for the short term on one hand and the medium to long term on the other whilst the history of economics and stock markets teaches us there are cycles – yes you get crashes, recessions, depressions and financial crises but they don’t last forever. Eventually recovery and a return to growth occurs. I think this is a useful counter view to the group think of politicians and journalists who only see a no deal Brexit as a catastrophe or disaster.

Finally a client of mine thought that the 3.2% weighted average tariffs on UK exports to the EU seemed low. I wrote back to her:

“The 3.2% figure seemed low to me as well but it is a weighted average, not applicable to all goods. Individual goods have different tariffs. For example lamb exports from the UK to EU will be 67% (according to the National Farmers’ Union). However the 3.2% figure is an average weighted by the amount of trade. This suggests that more larger volume products have much lower tariffs.”

I have asked JP Morgan for a source for that figure and if my understanding about trade weighted average tariffs was correct. If I am wrong I’ll post a postscript to this postscript post-haste! Have a good weekend.

The content of this blog is based on my own understanding of the UK economy and is intended as general investment information only.  Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Brexit – Outlook for the economy

Yesterday I listened once again to the excellent Karen Ward, a Chief Market Strategist at JP Morgan Asset Management. Prior to this role she was Chair of the Council of Economic Advisers for the Chancellor of the Exchequer advising the Chancellor on macroeconomic issues including fiscal strategy and Brexit. Previously she worked for a decade at HSBC’s investment bank in a number of roles, including Senior Global Economist. Suffice it to say she knows her stuff and moreover communicates her understanding very well.

The webinar yesterday was on Brexit notably on the economic impact of a no deal. She naturally set this out in the context of the politics – the complex multi-outcome game of chess, which appears to be entering its end game. I don’t intend to detail her political comments here but try to summarise the economics and the potential impact for investors.

Ward explained with a no deal we would fall under World Trade Organisation (WTO) rules where tariffs would apply on each product. However under the rules tariffs have to be applied uniformly across all applicable countries which would prevent the EU, should they be so minded, to arbitrarily set punishing tariffs on the UK’s exports. She stated that the weighted average of these tariffs would be 3.2%, a figure which surprised me as being low. Customs and regulatory checks would apply to goods and the UK financial services sector would lose its passporting rights into the EU. The UK would have to replace the 40 free trade agreements the EU has negotiated on our behalf, although 13 continuity deals encompassing 38 countries have been agreed. Please see https://www.bbc.co.uk/news/uk-47213842 on this point.

Ward then considered the Bank of England’s modelling of a no deal Brexit and explained the impact of disruptive and disorderly scenarios. The former would lead to an 3% contraction in the economy as measured by GDP (Gross Domestic Product), the latter an 8% fall.  My impression was she thought the former outcome was more likely. Under the less damaging scenario the unemployment rate would rise to 5.75% (currently 3.9%), house prices would fall by 14%, commercial property prices would decline by 27%, inflation would rise to 4.25% and the Sterling dollar exchange rate would fall to 1.10 at the trough. That said Ward noted the UK economy has held up remarkably well since the 2016 referendum. Although there has been a marked downturn in investment, consumer spending has been very supportive and the labour market resilient with very high levels of employment and wage growth. Ward also declared that Tory austerity was over – the implication being government spending would help boost the economy and that the Bank of England would cut interest rates in a no deal scenario.

On the downside Ward expressed concerns about falling export orders as EU companies source alternative suppliers, a weak PMI (Purchasing Managers Index)* and a low house-hold savings ratio which has fallen significantly since 2010. The latter is important as a buffer against rising costs.

Ward thought the outlook for Sterling was binary with the pound moving to either $1.10 or $1.40, depending on how favourable the outcome was perceived by investors. That said in the near-term downside risk is predominant. A weak pound is bad as we import inflation but there is an inverse relationship between the pound and UK stocks. As previously noted around 70% of the earnings from FTSE 100 companies comes from overseas and is derived in dollars, Euros and Yen etc.  When Sterling is weak and the earnings are repatriated they get a currency boost. Apparently after the referendum Sterling fell by 13% but the FTSE 100 rose 3%. In contrast the more domestically focused FTSE 250 index declined by 8%.

In summary I liked Ward’s analysis and conclusion. It seemed fair and balanced. She thought the UK was a dynamic and adaptable economy and whilst there would be short term pain she did not consider it would be a catastrophe. The clear implication is in the longer term there would be a recovery. How long it would take is an interesting question.

So what is my conclusion? I broadly think equities remain the best long term investment although the ride might be volatile. UK equities are very unloved, quite right you may say but have they been over-sold? They trade at a very large discount to other developed markets although in the near term the discount could widen. Global equities and UK smaller companies offer investors protection from damage to UK/EU trade. My conclusion is investors must think long term just as they had to through recessions in the past, the global financial crisis and the more recent Eurozone crises. That said I am aware that some of my clients are deeply concerned about a bad Brexit outcome and I have been recommending selected profit-taking cautious risk investment.

*The Purchasing Managers’ Index is a highly important monthly survey of business confidence in the private sector, covering both manufacturing and services. It is a good indicator of the direction of the economy.

The content of this blog is based on my own understanding of the UK economy as explained by Karen Ward and is intended as general investment information only.  Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Brief Stock Market Update

It probably hasn’t escaped your attention that global stock markets have been on the slide recently. The FTSE 100 ended at 7,686 on 29/7/19. Yesterday it closed at 7,198 a fall of 6.35% in little over a week. In the US the S&P 500 fell from a historic high of 3,026 on 26/7/19 to 2,884 yesterday i.e. down 4.7%. The principal causes of the losses were the old chestnut of US/China trade wars, a fall in the value of the Chinese renminbi from official currency manipulation and a drop in US interest rates, the first for more than a decade. Investors have interpreted this as a sign the US economy is slowing and may be heading for recession. In other circumstances monetary easing is positive for stocks – interest rates will be lower for longer whilst bond yields fall, thereby making equities relatively more attractive. This was what QE achieved but this time markets have drawn the opposite interpretation – it’s bad. In contrast gold, a traditional safe haven asset in contrast has rallied.

For UK investors we could throw into the mix the ongoing saga that is Brexit. Markets hate uncertainty. However it is important to remember the effect of Brexit on the UK economy and investments is complex and nuanced. Take the issue of a falling pound. On Monday 29th July the threat of a no deal Brexit caused the FTSE 100 index to soar by just under 2% in a day. The FTSE 100 index rose because around 70% of constituent company earnings are from overseas, generated for example in Dollars, Yen and Euros.  When converted back to pounds weak Sterling gives a boost to these earnings. However this largely went unreported;  a falling pound is only viewed as a bad thing in many quarters. The reality is there are pros and cons for an economy when a currency falls. The UK market’s fall of more than 6% since the end of July was primarily due to global events.

Whether these events signal a wider sell-off is difficult to say. I am not superstitious but September and October are often bad months for stock markets and a number of commentators have expressed fears of further falls. Undoubtedly the global economy has slowed and geo-economic and geo-political events are a risk to investments. How they are handled by those in charge will be crucial for good outcomes. For the rest of us we have to concentrate on what we can control and not be too worried about what we cannot. Investment reviews may be in order with profit-taking and risk reduction to protect capital. In any event a long term perspective is required to ride the volatility.

The content of this blog is based on my own understanding of the global economy  and is intended as general investment information only.  Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Investment, inheritance tax and business relief

Much of my time is spent advising clients on how to grow their investments. This involves protecting clients’ capital from various threats that can gobble it up, as fast as my Cocker Spaniel devours her supper. There is not a lot of point in planning for growth if you do not plan for protection of capital. Threats include stock market crashes, taxes, no longer suitable investment strategies and under-performing fund managers. That is why investment reviews are important.

In this blog I want to continue on the theme of alternative investments, specifically one that addresses one of the greatest threats to capital, inheritance tax (IHT). You can spend years building an investment portfolio only to find after your death it is decimated by a tax that wipes 40% off its value after various allowances. An antidote to IHT is legislation called Business Relief (BR). This was previously called Business Property Relief (BPR) and was introduced in 1976 to exempt business owners from IHT on business assets.  It also applies to shareholders in certain qualifying smaller companies. Providing the assets are relevant business property* investors are exempt from IHT after two years providing they are held at the date of death. The government is naturally keen to encourage investment in small UK companies, which is why tax incentives are provided.

The use of BR has become a mainstay of good IHT planning. It has two distinct advantages over other tax mitigation strategies notably outright gifts or use of trusts. These require a seven year waiting period for IHT exemption and the donor must relinquish all control of the asset gifted. There is no recall. In contrast BR applies after just two years and investors retain full rights over their investment. So if their circumstances changes and they need access to their money they can sell their shares and spend the money as they see fit, although of course they will lose the IHT exemption. BR address perhaps the most important reason why people don’t undertake IHT planning, the fear of losing access to capital. It also avoids the complexity of trusts.

Over the years a good competitive market has developed in tax efficient investments using BR. There are a host of providers including Octopus, Blackfinch, Time and Foresight and two types of BR investment schemes:

Investment Backed

These are managed portfolios of qualifying AIM shares. The AIM is the alternative investment market, part of the London Stock Exchange. It is a stock market for small companies. They are not all start-ups or fledgling companies and include established business such as clothing company ASOS, Fevertree Drinks and Youngs & Co’s Brewery. Domino Pizzas was AIM listed before moving to the main market as was Tottenham Hotspur football club before it went private. Not all AIM stocks qualify for BR, notably property and finance companies.

A number of my clients have managed portfolios of AIM companies which have delivered outstanding if volatile returns in the medium term. Since 2013 AIM shares can be held within an ISA which means dividends are not taxed.

Asset Backed

These are investments in one or more unquoted trading companies set up by the provider. The company invests in assets such as renewable energy, notably solar and wind, battery storage, property lending, anaerobic digestion, infrastructure and smart meter leasing. They benefit from physical assets, government subsidies and long term contracts with sustainable cash flows.

Asset backed BR schemes typically have an objective of steady capital growth and preservation and usually have a target return, for example 3.5% p.a. net of all ongoing management charges and costs. Many providers do not take their management fee unless investors receive the target return. They are especially suitable for cautious risk clients, ethical investors and people looking to deploy excess cash for a potentially higher return than bank interest but without taking undue risk.

A principle downside of BR investments are charges tend to be relatively high. Initial charges which have all but disappeared from mainstream investments such as unit trusts and OEICs (open ended investment companies) are levied by BR providers. These are typically 2% or 2.5% although IFAs may be able to negotiate discounts. Ongoing costs are also higher than unit trusts and OEICs. The other main disadvantage of BR investments are they are not covered by the Financial Services Compensation Scheme (FSCS) in the event of failure. This is no different to investors in any other direct shareholding.

Conclusion

The use of BR is an excellent way to mitigate against IHT, quickly, simply and without a loss of control of capital. An investment of £50,000 will result in an inheritance tax saving of £20,000 after just two years if retained until death. On death there will be no capital gains tax either. The underlying investments themselves will typically complement mainstream portfolios and add diversity. A number of providers offer accelerated tax relief with an option to add life assurance to cover the tax on death within two years. As a group life arrangement there will be no medical underwriting and acceptance is guaranteed unless you have been diagnosed with a terminal illness. That is the only question investors are likely to be asked. An additional charge is levied if the life cover option is selected.

There is a natural reluctance for people not undertake IHT planning. The reasons are varied but include loss of control, complexity and inertia. However someone once said inheritance tax is a voluntary tax paid by people who love their children more than the taxman, and inaction may be costly. In reality some of the barriers are easily overcome.

Finally BR is also available to Enterprise Investment Scheme (EIS) investors. These are the super heroes of tax efficient investments with a variety of other tax benefits including 30% income tax relief. More on EIS another time.

*Relevant business property. This includes a business or interest in a business, qualifying AIM shares, unquoted securities or land, buildings, plant or machinery for the purposes of a business. Relief for the latter is 50%. For a technical description see:

https://www.rossmartin.co.uk/private-client-a-estate-planning/inheritance-tax-probate/619-business-property-relief-iht

The content of this blog is based on my own understanding of Business Relief and is intended as general investment information only.  Nothing in this article should be construed as personal investment advice for example to invest in AIM shares or other BR schemes. You should seek individual advice based on your own financial circumstances before making investment decisions.

The State of the Nation – the US Economy

A number of commentaries I have read and listened to recently have been on the same theme, the US economy. Officially US growth is now in its longest expansion in history and with a dramatic shift in monetary and interest rate policy by the Federal Reserve, the US central bank, both equities and bonds have rallied in the US and elsewhere in 2019 after a sharp sell-off in the last four months of 2018. Recently the Dow Jones Industrial Average, the S&P 500 Index (the most representative stock market index of the US economy) and the technology laden Nasdaq all posted new highs.

Not all is rosy however with risks and threats from a slowdown as US tax cuts fall out of the equation, trade wars, political risks and a rising oil price. However when you look beyond the headlines the position is more nuanced and complex. Here are some random facts and observations from industry professionals that I found particularly interesting:

*China is expected to overtake the US as the world’s largest economy in 2020 according to John Husselbee, head of multi-asset at Liontrust. He sees ongoing geopolitical and economic tensions to be ongoing between the two superpowers even beyond the issue of tariffs, for example on the adoption of US or Chinese technology. I also suspect that the US economy will retain its global dominance even if the numbers place it in second place. So it might be the case that if China sneezes the world will catch a cold but if the US sneezes the world will get flu. One reason is that oil, gold, commodities and many emerging market bonds are all priced in dollars.

*The US economy has slightly decelerated in the first half of 2019 although according to Charles Kantor, portfolio manager of the Neuberger Berman US Long Short Equity fund (from an article in Investment Week along with the quotes from Pichoud and Lau below) the US macroeconomic backdrop is positive and supportive of growth. Karen Ward, a Chief Strategist at JP Morgan observed the US consumer economy is strong with low unemployment, wage growth and good personal balance sheets. However in my view rising inflation and a return to a policy of interest rate rises could be change this assessment.

*Adrien Pichoud, chief economists and head of multi-asset at SYZ Asset Management highlighted concerns about the US industrial sector where export order growth, CAPEX (capital expenditure) and job creation have effectively ceased. The question is whether this will be contained in the industrial sector or impact the wider economy.

*Larry Lau of the Trium Diversified Macro fund observes that fiscal measures to encourage corporate America to repatriate business back to the US has led to a mountain of debt whilst concerns about global trade incurs costs for business.

*The Bank of America Merrill Lynch’s monthly sentiment survey of fund managers showed investors are at their most bearish since the global financial crisis. Global managers have cut exposure to equities to a 21% underweight, the lowest since March 2009. I have to admit that surprised me.

So what are to make of it all and what are the prospects going forward. Those who called the end of the US bull market clearly have got it wrong. Three or four years ago I remember fund managers saying that the US was very highly valued and they were reallocating capital to the UK and Europe which were more attractively valued. The US market has continued its rally driven by earnings growth. It has been a gift that keeps on giving. I conclude there are potential rewards from equities and clearly risks as well. Whenever is this not the case? Karen Ward suggests to position portfolios defensively there should be a shift from smaller companies to large companies and from growth to value.* You will recall during recessions smaller companies fare poorly – evidence of this surfaced in late 2018 where prices were particularly badly hit. She also suggests a focus on quality. This will include companies with low levels of debt, strong barriers to entry and sustainable cash flows.

I conclude there are good reasons  to be invested in equities especially for the long term where you can ride out the short term volatility but also reasons or be cautious. I like Terry Smith of Fundsmith Equity fame. He takes the view even if you can accurately predict the global economy what can you do about it? He concentrates on what he can control – picking high quality companies and holding them for the long term. It has been a very successful investment strategy. I love his comments on his fund fact sheet:

No Fees for Performance

No Up Front Fees

No Nonsense (my favourite!)

No Debt or Derivatives

No Shorting

No Market Timing

No Index Hugging

No Trading

No Hedging.

*Growth and value investing are frequent terms you will hear banded about. The article from the US Fidelity website offers a good explanation:

https://www.fidelity.com/learning-center/investment-products/mutual-funds/2-schools-growth-vs-value .

The content of this blog is based on my own understanding of US economy  and is intended as general investment information  only.  Nothing in this article should be construed as personal investment advice for example to buy equities or US funds. You should seek individual advice based on your own financial circumstances before making investment decisions.

Investment Trusts – Part 2

Before reading this article you may need to read part 1 written just over a month ago in order to refresh your memory on the technical backdrop. However to remind you of the key point – investment trusts have a closed end structure in contrast to OEICs and unit trusts which are open ended funds. Investment trusts have a limited number of shares in issue, whilst OEICs and unit trusts create and redeem shares or units respectively depending on investor demand. What this means is that the value of an investment trust’s assets (its Net Asset Value or NAV) may differ from its market capitalisation and the shares trade at a discount or premium to the NAV per share. If you get this, understanding investment trusts is a whole lot easier.

In this article I want to explain the benefits and uses of investment trusts for investors.

1. Investment trusts may mean investors can buy assets cheaper than their inherent value

Consider an investment trust trading at a discount to its NAV. Let’s us say the NAV per share is £1. What this means is if you add up the value of the investment trust’s assets i.e. the stocks and shares held, deduct liabilities, and divide by the fixed number of shares in issue each share has an underlying value of £1. However if the trust trades at a discount of 10% to its NAV the share price of the trust on the stock market will be £0.90. In other words an investor buying the trust will acquire £1 of assets for just £0.90. In this situation investors hope the discount will narrow and the share price will move closer to the NAV. If so investors benefit. In some cases this may be without any underlying investment gains on the trust’s portfolio of assets i.e. change to the NAV. For example if the share price rises to £0.96, investors who bought at £0.90 will see their investment rise by 6.67%.

The question is what might cause the share price to rise and the discount to narrow? It is all down to investor demand. To answer the question you have to ask why did the discount arise in the first place. The share price may less than NAV per share, the true worth of the shares for several reasons. One is investors lack confidence in the fund manager and their investment process or the outlook for the trust’s portfolio may be negative. If however an underperforming fund manager turns the investment around or is replaced by a new fund manager the market may take a more positive view of the trust, pushing up the share price. Of course the risk is that the discount widens and the share price falls.

Investors may also buy in at a premium to the NAV and pay more than their intrinsic worth of the shares. The most highly rated investment trusts with top fund managers trade at a premium. Investors buy in expecting further gains to both the NAV and the share price. However if you buy at a premium there is a risk the share price falls, moving closer to its NAV.

In contrast to investment trusts open ended funds are normally priced at NAV and investors cannot buy assets cheaper than their inherent value.

2. Investment trusts can borrow to invest unlike OEICs and unit trusts and may enhance gains

This is called gearing and it magnifies gains and losses. It makes investment trusts more risky than open ended funds although many trusts do not using gearing. Consider a trust which has £50 million of assets which borrows £10 million. If the trust gains 20% the value of the trust rises to £72 million. If the £10 million loan is repaid the net assets are now £62 million. The rise in value of the assets from £50 million to £62 million represents a rise of 24%, more than the 20% the market gains, although borrowing costs have to be taken into account. The reverse effect happens in a falling market, gearing amplifies losses.

3. Investment trusts can retain income for later distribution

OEICs and unit trusts are required to distribute all income they receive, both dividends and interest. However investment trusts can retain up to 15% of their income to distribute to shareholders at a later date. This enables trusts to smooth their income payments to investors as well as increase the dividends an investment trust pays out to its investors year on year. There are a significant number of investment trusts that have done this for 20 years or more and these are called “dividend heroes.” Data from the Association of Investment Companies (AIC)* and Morningstar show three trusts that have increased their dividend per share for 52 consecutive years – the City of London Investment Trust (UK Equity Income), Bankers Investment Trust and Alliance Trust (both in the AIC Global sector). The first ever trust, the F&C Investment Trust launched in 1868 has done so for 48 years.

Whilst the first two benefits might appeal more to growth investors taking more risk, investment trusts are clearly attractive to income seekers wanting steady and rising dividends, for example in retirement. In contrast the yields on open ended funds are more likely to fluctuate, be less dependable and less likely to keep pace with inflation.

4. Investment trusts can invest in less liquid assets than OEICs and unit trusts

Investment trusts are much more suitable for investing in less liquid assets such as physical commercial property, unquoted shares or infrastructure than OEICs and unit trusts. This is due to their closed end structure which means an investment trust manager is never required to sell the assets of the trust to pay exiting investors unlike their OEIC and unit trust siblings. If an investor wants to dispose of an investment trust they sell their shares independently on the stock market to a third party. There is no involvement of the investment trust manager and there is no call on the trust’s assets. It is no different in principle to owning shares of any other company. Let’s say lots of investors want to sell their shares in GlaxoSmithKline or HSBC they don’t sell them back to Glaxo or HSBC, they sell them on the London Stock Exchange to someone else. Glaxo don’t have to sell a research centre or HSBC close a few bank branches to pay out investors.

Just to make sure you are paying attention, here is a question. If lots of people sell their shares in an investment trust what happens to discount if there is one, or to a premium? I knew you were on the ball! You are correct, the share price falls and the discount widens. If there is a premium it will narrow and move closer to the trust’s NAV per share.

In contrast if lots of investors want out of an open ended fund they sell their units back to the fund and if there is insufficient cash available the fund manager will have to sell assets to raise cash. They may be forced sellers at depressed prices which reduces investment returns. If the underlying assets are illiquid there may be no market for them and the fund manager may be unable to deal. This may necessitate gating of a fund, i.e. stopping investors from redeeming their investment, like the Woodford Equity Income fund as explained in my last blog. As noted unit trusts holding commercial property on some occasions have had to close to dealing.

The fact that investment trust managers know there will never be a call on the trust’s assets to meet investor demand means that they can safely invest for the long term and that’s a big plus.

5. Investment trusts tend to outperform OEICs and unit trusts over the long term

The reasons for the superior returns are partly due to lower management charges levied by investment trust managers. However with the abolition of commission paid to advisers and payments to platforms by OEICs and unit trusts at the end of 2012, annual management charge differentials have fallen in recent years. Investment trusts are also more likely to have performance fees which adds to their costs but my assessment is the ongoing charges figures (OCFs – the annual management charges plus additional fund expenses) of investment trusts are generally lower than OEICs and unit trusts.

Other factors for the superior returns include avoiding cash drag (retained income can be invested whilst open ended funds may retain a cash buffer for redemptions) and the ability to invest for the long term. Gearing is another factor. Finally investment trusts tend to be smaller in size than the big beasts of the open ended world and therefore are more nimble with their investments. Of course there are plenty of exceptions here with poor performing investment trusts and OEICs and unit trusts with cracking returns. As ever good fund selection is crucial.

One interesting fact the AIC highlighted in a recent seminar I attended was the investment trust outperformance of sister funds. Many of the big fund management groups run both investment trusts and OEICs or unit trusts, for example Baillie Gifford, Janus Henderson, JP Morgan, Invesco, Fidelity and Schroders. In some cases there are equivalent investment trust and open ended sister funds, managed by the same person or team. They have similar investment strategies, asset allocations and stock selection. Typically over the medium to long term investment trusts have outperformed their sister OEICs or unit trusts.

Summary & Conclusion

Demand for investment trusts has risen in recent years but they have disadvantages as well as benefits. There are no outright ethically managed investment trusts as there are for open ended funds although there are a couple of environmental trusts and many investment trusts adopt ESG principles. ESG is Environmental, Social and Governance and has become a bit of buzz word amongst investment companies but in my view ESG is a very light green form of socially responsible investment (SRI), without strict adherence to a set list of excluded investments such as arms producers, tobacco stocks or companies involved in animal testing. There are no passive index tracking investment trusts, no equivalent to gilt and mainstream corporate bond funds and limited cautious risk multi-asset trusts. The point is investment trusts have limitations in what they can offer certain investors.

Whilst there is plenty of choice of trusts in major AIC sectors such as Global or UK Equity Income in some sectors it is very limited. For example there are just three environmental trusts, two equity and bond income trusts and one property securities trust. In part this in because there are only 338 investment trusts (excluding Venture Capital Trusts, VCTs) compared to around 3,000 OEICs and unit trusts.

So in conclusion, despite their complexity and some additional risks investment trusts can play a valuable role for suitable investors with their unique benefits and advantages, not enjoyed by OEICs and unit trust. They will however complement open ended funds not replace them.

*The AIC is the UK’s only trade body for investment trusts with around 90% of all trusts being members. Please note the terms investment company and investment trust are used interchangeably. The former is a more accurate description of what these investment vehicles are although the latter is still in common use.

The content of this blog is based on my own understanding of investment trusts and is intended as general investment information  only.  Nothing in this article should be construed as personal investment advice for example to buy  investment trust shares. You should seek individual advice based on your own financial circumstances before making investment decisions.

No bank branches were closed as a result of this article.