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Do the maths

In my last few articles, I have been discussing the current performance of the major asset classes and speculating overthe future potential forasset allocation.

This short series of articles has spanned a period of a couple of months, during which time markets have been behaving very erratically (equities) or confirming a trend (cash, fixed interest and property). In this concluding article, I will provide an update and speculate further on prospects for the foreseeable future.

First, cash. Bank base rates have fallen since my most recent article but that was expected. Cash funds cannot possibly hope to project returns any higher than around 5 per cent a year, which might not seem attractive for some investors.

Of course, it is not attractive when compared with many asset-backed funds over the last few years. However, those heady returns from more exciting asset classes have disappeared,at least temporarily, and investors should be encouraged to note the availability of real ratesof return over inflation, whether from cash orany other investment.

If we assume future inflation to be 3 per cent, then a 5 per cent return for the foreseeable future represents a real rate of return of 2 per cent. This does not sound a lot but any premium at this level becomes attractive over the years. It sounds a bit strange but it is true, especially if alternative investments do not offer obvious value,as I will suggest in the remainder of this article.

On to fixed-interest investments. Returns from this asset class have not changed much over the last few months. Perceived wisdom might suggest that the value of fixed-interest issues, such as Government bonds and corporate bonds, should rise when interest rates fall but this is not always true if the marketis already anticipating short-term rate reductions. This has been the case in the UK for many months. In fact, the market has for some time been assuming reductions rather than anticipating them and fixed-interest bonds have been priced accordingly.

Further reductions in interest rates are widely expected but the fixed-interest market has factored these thoughts into prices, so do not expect much change. Sure, the influence of supply and demand enters into our thoughts but with probable limitless supply (the globalisation of the fixed-interest market, Northern Rock and increased Government borrowing), it seems certain that this will remain a pure market.

Government bonds continue to offer redemption yields between 4.5 and 5 per cent, as they have done for many years and, as I have just suggested, we cannot really expect much change from the yields or capital values in this asset class for some time yet. The only difference from cash is the bit of a gamble on longer-term interest rates, one way or another.

Staying with fixed interest, corporate bonds offer a premium return over Government bonds but, as has been the case for many years, higher-grade investment bonds do not offer any real attraction over gilts, as shown by the small but indicative selection quoted in the Financial Times. AAA-rated bonds (Network Rail is the quoted example) offer a redemption yield of around 5 per cent, which is little better than gilts, while a typical A-rated bond (France Telecom) offers around 5.5 per cent.

Investors wanting to access cash or fixed interest should go directly to the market rather than use charge-loaded funds which rarely offer any added value, with the possible exception of well-managed funds in higher-yielding corporate bonds. Even within pension planning, the proliferation of self-invested personal pension launches with attractively low fees should be a good indication to advisers that provider funds are not necessarily attractive here. Heresy, perhaps, but I don’t think so.

So, 5 per cent from cash or fixed interest. Not bad. A real rate of return over inflation. However, for more adventurous investors and their advisers, what other asset class might be attractive?

I noted in a recent article that returns from commercial property were falling and there was a definite trend developing. This trend has continued with a vengeance. Rental yields a little over 4 per cent a year are more than offset by reductions in capital values (source: Investment Property Databank), leading to significant losses inmost or all commercial property funds.

The mathematics do not offer much prospect of a reversal in this trend in the short term and the fact that some property fund managers have imposed six-month waiting periods indicates that they do not think so, either.

Unless we are heading for recession, we would assume that demand for commercial property should not fall and, therefore, rental yields on good quality propertyshould not crash. If this logic holds good, then property values might fall furtherbut the rental yields ongood portfolios or funds should limit the downside.

I suppose what I am suggesting is that the panic buttons do not need to be pressed at the moment but the volume of sales of property funds by the financial services community (including myself) should perhaps calm a bit for the time being. Still, if rental yields from good quality property funds start to level off at 5 per cent or thereabouts, then it will be hard not to have at least some exposure to this asset class in a well-structured portfolio.

Finally, equities. There is no point in me simply repeating my thoughts from previous articles at any great length so I will simply provide a summary. If corporate profits continue to increase and profit warnings from our major companies are few and far between, then the mathematics are screaming at us that the further the stockmarket falls, the better value that equities become.

A FTSE index lower than 6,000 suggests a medium to long-term return from equities of around 10 per cent (refer to my previous articles or price/earnings ratios or dividend yield).

I finish on this humble suggestion. Expectations from cash and fixed-interest investments cannot really exceed 5 per cent, excluding charges. Property funds may have yet further to fall but there has to be a support level, especially within good quality property funds, from the rental yield on long-term lets to prime tenants. Fire sales of units in property funds will, I think, prove foolish within the year.

Equities have therefore become even better value than a couple of months ago. The mathematics say so. The logic also says so. If one is disinvesting from one asset class, there has gotto be a better alternative.I cannot get turned on by5 per cent returns frommy portfolio but I am a bitof a gambler, so I am paying much more attention to share and fund selection within the equity market.

Fancy a bit of fun? Gold values have rocketed over recent months but the auction price of gold coins has not. Drop in at your local auction and buy the odd sovereign, half-sovereign or krugerrand. They might not be every coin collector’s dream but you will find yourself bidding only against bullion dealers.

Please do not pass this last tip on to clients or the FSA will be on our case. However, if you have nothing better to do on a Saturday, then an enjoyable and profitable experience might await you.


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