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Break away from the pack

Sometimes it is too easy to slip into a familiar pattern. I think some parts of the investment industry are in danger of falling into this position. At times, the industry seems stuck in an intellectual rut, unable or unwilling to embrace new methods or new ideas.

Witness the dreary and unimaginative debate between active and passive fund managers. This slugfest of claim, counter claim, statistics and counter statistics reminds me more of two weary boxers who have gone the distance than a demonstration of an industry bursting with new ideas. Worse still, the industry is dominated by active management investment so-called professionals who appear to believe only they can be trusted to deal with the heavy and “complicated” world of investment.

Of course, the fact that the vast (and I mean vast) majority of active fund managerscannot even beat the passive index might just cause some to question the value of their expert opinion. But more important, it is dangerous to believe investment can and should only be controlled by so-called experts. Like most new ideas, fresh perspectives and intellectual risks will more often than not come from outsiders. In other words, for the industry to flourish and grow, it needs to think differently.

For example, with-profits investment remains one of the most popular investment methods in the industry – probably because it gives the perception of offering both guarantees and equity-like returns. But with-profits is a medium which dates back well over 100 years. Is this a reflection of a fund which has stood the test of time, or the failure of an industry to offer better and brighter alternatives?

Personally, I think we are seeing the answer to that very question become apparent now. As equity markets have become more volatile and gilt yields have plunged, with-profits funds have come under severe pressure.

The pressure has been so great that, rather than try to create a better alternative, the industry has subtly altered the structure of with-profits by adding terminal bonuses and market value adjusters. Over time, with-profits returns have taken on a much higher risk profile but I suppose it was hoped that no one would really notice.

This leads me to my main criticism of with-profits. Although it has been around for years, in these days of popular investment, is it still really best practice to place your client&#39s future in a fund where the inherently complicated bonuses and returns are wrapped up in language which makes them even more difficult to understand?

I first heard this sort of criticism of with-profits investment over 10 years ago but in that time I have not seen a genuine attempt to simplify with-profits or for anyone to try to create a genuine and clear alternative.

This leaves a huge opportunity for new developments and fresh thinking. For example funds can be developed which are clear, simple and operate on the basis of an investor&#39s idea of risk as opposed to the industry definition.

Essentially, the investorperceives risk in two forms. Absolute risk, where they can lose some of their capital, and opportunity cost, where they lose returns when their investments fail to keep pace with other returns.

To the investment industry, there is very little difference between these two forms of risk. But from the client&#39s point of view, they are often very different. More often than not, clients will tend to get, understandably, upset when their capital is eroded but will place less emphasis on opportunity cost.

With all this in mind and a little bit of fresh thinking combined with the flexibility of derivatives, is it not possible to create fund structures which are more in tune with the client&#39s idea of risk and risk management than the industry&#39s view?

Using a combination of option investments, it is possible to develop a range of funds which we believe change the nature of investment risk for the client, effectively skewing risk away from absolute risk and towards the more tolerable opportunity cost.

These funds also provide the advantage of not requiring any market growth to provide a full bonus and, uniquely, will still pay a partial bonus provided the market has not fallen more than 5 per cent, in the case of Scottish Life International&#39s With Bonus fund range.

The effect is to producea range of investment funds that should provide returns well in excess of the risk-free rate of return but witha tolerable form of risk for most investors.

Unlike with-profits, risk-defined funds such as these are clear, simple and easy to understand. Rather than try to hide risk, they redirect risk to a form which is more palatable for the investor. But this is one innovation which has been developed outside of the industry. The industry needs more new innovations like this, more examples of thinking differently. The best way to stay outside of the flock is not to act like a sheep.


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