Does conventional wisdom regarding decreasing risk as you reach retirement actually work?
Pension investors special
In my last column, I discussed the temptation facing pensions investors to take money off the table in the face of recent stock market gains, the gist being that while it may seem logical to try and take profits when your investments have gone up, few manage to time the market successfully, and ultimately it depends on how long you have left before you need the money.
Conventional wisdom has it that the closer you are to your retirement date, the less you can afford for your investment portfolio to take a dip, because you may not have time to recover the lost ground. Younger investors, with a longer ‘journey’ ahead, have the luxury of time on their side and can, according to the same conventional wisdom, afford a bumpier ride.
A set of model portfolios called the Adviser Fund Index, published by data provider FE, illustrates this well. Each index shows the performance of a ‘basket’ of funds (mainly OEICs), based on the real-life recommendations of a panel of independent financial advisers. There are three portfolios – AFI Aggressive, Balanced and Cautious – designed specifically to suit investors at different stages in their lives. Panellists were asked to choose funds suitable for an investor in their late 20s (Aggressive), mid-forties (Balanced) and late fifties (Cautious).
As one might expect, the aggressive portfolio has outperformed its cautious and balanced counterparts over one, three, five and ten years, and over longer periods the margin of outperformance grows.
However, it has done so at the cost of significantly increased risk. Over five years, the aggressive portfolio records volatility of 9.48%, almost double the volatility recorded by the AFI Cautious index (5.2%). Another useful ratio used by analysts is maximum drawdown – which shows you the maximum you could’ve lost if you’d put your money in and taken it out at exactly the wrong times. An investor holding the funds in the AFI Aggressive portfolio, if they’d bought and sold at exactly the wrong time, could’ve lost twice as much as an investor in the cautious portfolio.
It is this ability to recover ground lost during these periods of ‘drawdown’ that is so important for investors with longer time horizons.
|AFI Aggressive TR in GB||0.10||1.98||4.84||17.49||38.03||70.27||98.40|
|AFI Balanced TR in GB||0.03||1.60||3.30||13.27||26.74||52.02||77.35|
|AFI Cautious TR in GB||-0.08||0.84||1.61||9.20||18.68||38.86||61.31|
These indices are made up of OEICs, but investment trusts are a particularly attractive option for those who have time on their side. They are closed-end structures – the manager doesn’t need to worry about selling holdings if investors want to sell their shares, unlike OEIC managers who must meet investor redemptions by selling their holdings. As well as protecting investors who wish to remain invested, this security allows investment trust managers to invest more freely, safe in the knowledge that the capital they invest can stay where it is even if things hit a rocky patch.
They also have the ability to ‘gear up’, borrowing money from a bank which they can invest alongside funds provided by shareholders; which has a significant accelerant effect – though this works in both directions unfortunately! Gearing can be used to take advantage of short term opportunities (tactical gearing) or put into place on a more permanent basis (structural gearing) and I tend to think the latter, given what I’ve already said about market timing, is generally preferable.
A further benefit to the closed-end structure is the presence of an independent board of directors – whose job is to monitor the performance of the manager and, if necessary, take steps to find a new one should it fail to remain on top form.
- What characteristics make sense for a long-term investment?
- Active/unconstrained management style, but not too specialist
- Consistent methodology
- Some gearing – preferably structural
- On a discount, or at least not much of a premium
- Low base management fee
- Long manager tenure and clear ‘buy-in’ (e.g. via ownership of shares)
With these criteria in mind you could approach portfolio construction in a number of ways, building a diversified portfolio of your own – drawing in trusts which invest in specific regions and asset classes – or buying into a global or multi-asset fund which does the asset allocation for you.
Investment ideas for long term horizons
The following trusts feature some or all of the characteristics detailed above – though whether they are suitable for your pension depends wholly on your personal circumstances; so this is in no way a suggested ‘portfolio’.
A global ‘manager of managers’ proposition with an experienced management team and very low ongoing fees. The trust in its current form has a relatively short track record and trades on a significantly wider discount than the average trust in the global sector.
Edinburgh Worldwide Investment Trust
A highly-active global portfolio with a focus on immature, but not necessarily small, companies with disruptive technology or products. The trust might suit those who believe that technology will be a major driver of returns in the coming years.
Henderson Opportunities Trust
This trust is managed by James Henderson with a completely unconstrained approach, investing primarily in smaller companies – many of which are in the AIM market, right at the bottom of the market cap scale. The trust has recorded some big highs and lows, and often trades on a whopping discount, so it’s not for the faint hearted – but long term investors have been rewarded.
Scottish Oriental Smaller Companies
Managed with a restrained, somewhat cautious, approach this trust offers exposure to the Asian economies, tempered with a capital preservation approach that has delivered solid returns in both good and bad periods for equity markets in the region.