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Thursday, 25th April 2024 |
| The economic cycle & investor trends |
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| Following a market correction the challenge to investors is to understand that the world has not ended and economic recovery will return to the markets. Paul Martin looks at how the different stages of the economic cycle affect the appetite for risk and leverage for investors. |
The recent market downturn has had a profound influence on the way we think about our personal investments, our preferences for wealth management products and services and who we select to provide them.
Take geared property investments. Over the last 10 years, both single asset and property portfolios were offered to a receptive Irish market. Investors were drawn to funds that had high levels of debt (75% - 80%) that magnified the return on the equity invested. A number of consecutive years of growth in asset valuations and returns created an unrealistic expectation of double digit growth in the minds of investors and the implications of deteriorating asset values were not always fully appreciated. With declining property asset values in excess of 20% - 25%, many geared property funds are now worth less than the debt. This scenario can expose a fund to the risk that the financing bank may call on investors to inject further equity or risk a collapse of the fund by a calling in of the loan. Investors now realise that the benefits of geared investment funds in a rising market can be quickly wiped out by the corollary effect in a falling property market. A supportive debt provider with no inherent LTV covenants is critical to the fund’s ability to “ride out the storm” of dramatically reduced values in an illiquid market.  | | Paul Martin |
So what can we expect going forward? Will this type of investment ever regain its popularity? As we adjust to the realities of the changed investment market, it is worth remembering that our changing habits and preferences in managing our personal investments tend to follow the overall ‘investment market cycle’. Each phase of the cycle is associated with different priorities for investors and so demand for a specific set of products and services.
Wealth management
In the slow growth phase of the cycle, where relatively stable investment market conditions prevail, the majority of investors are seeking a wealth management service, satisfied with typical asset classes and average single figure benchmark returns. Investment strategies are typically focused on mainstream asset classes in a diversified portfolio with low to no rates of gearing. During this investment phase investors tend to be focused on achieving annual returns of 3% to 4% in excess of inflation, with a limited appetite for a higher risk/ higher reward type of investment opportunity.
Wealth creation
Markets may then enter a strong growth phase (not normally as meteoric as recent times) and investors start to look for higher returns that will add to their wealth base thus creating a client demand for a wealth creation service. Portfolios concentrate on specific single asset investment opportunities, requiring gearing to drive enhanced returns from the underlying asset. In property, geared funds, discrete single asset transactions and club deals become popular. In equities, the demand for geared equity funds, margin lending or contracts for difference (CFDs) grows significantly.
A focus on double digit returns by investors tends to occur in the boom phase of an economic cycle. Client expectations become set for annual rates of return between 10% and 20%, often on the back of one or two successful investments. This level of return can be targeted at any given time by taking a higher degree of risk in the product selected for investment. It should however be realistically restricted to a relatively small percentage of a client’s over all portfolio.
Borrow to invest facilities were another feature of the recent strong growth phase of the cycle, fuelled by the availability of cheap debt. The schemes are typically structured as a personal loan providing liquidity to high net worth investors who are asset rich, income strong and low on liquidity. Depending on the investment, borrow to invest facilities can range from 50% to 100% loan to value and are normally on the basis of full recourse by the bank to the borrower. Investors need to be sure of their capability to comfortably shoulder the burden of interest costs and risk where equity is acquired in this fashion for investment. They should seek to fix interest rates for the duration of the investment to achieve certainty of costs or ensure that a “stress test” is applied to any interest rate assumptions they make in estimating the cost of borrowing the equity over the term of the investment. | | Source: Bank of Scotland (Ireland) |
Wealth preservation
The investment cycle typically reaches final maturity with a prolonged market correction or downturn (again not normally as severe as the current correction). This sees clients retreat to low or no risk investment portfolios, and a move to focus on preservation of remaining wealth. This phase is characterised by capital guaranteed products and a focus by clients on capital security over investment return. For clients with a low risk/return outlook, these products are a staple need at all times, but at this point in the cycle, their popularity comes to the fore. The priority becomes the provision of guarantees on capital and guarantees on return. Investors will sacrifice potential higher investment returns available through investment in real assets, for the surety of modest or low guaranteed returns e.g. interest on deposits, coupon on gilts, minimum guaranteed returns on tracker bonds.
A recent example is the Bank of Scotland (Ireland)’s Phoenix 1 market linked deposit account, which offered the higher of a 10% minimum return over 5 years or 50% of the growth in the Euro Stoxx 50 Index, with a minimum investment of €25,000. Capital secure tracker bonds should be evaluated based on a range of criteria - term of investment, percentage of participation in the target index, likely level of performance volatility in the index or basket of indices to be tracked by the investment, and the size of any minimum return offered.
Still within the realm of capital preservation but maintaining a ‘weather eye’ towards wealth recovery, investors can consider specific themed tracker bonds that will focus on a specific equity or commodity theme thus narrowing the basis of return and increasing the potential for maturity values whilst still guaranteeing all or the majority of the original capital invested.
Another feature of the ‘correction’ phase is the growing need for protection products. With underlying asset values at a reduced level and residual debt values at a relatively high level within their overall portfolio, investors tend to re-evaluate the need and benefit of life assurance and serious illness cover as well as income protection cover in the event of long term disability or illness. Many investors become cognisant of the value of their own contribution towards the success of their business and investments and the effect that their premature demise would have on the value of their estate.
During the ‘correction’ phase in the markets, investors realise that ongoing income from investments (dividends from shares or rents from properties can decrease, and the previously assumed “buffer” for ones dependants may not be reliable. The provision of life cover, serious illness cover and income protection cover offer a relatively cost effective solution to the management of potential risks. Investors should always allocate an amount of net income to arrange such protection cover.
Wealth recovery
As investment conditions stabilise and begin to turn upwards, and the cycle moves into the “recovery” phase, the investor’s focus switches to wealth recovery – a conscious decision to start taking risks again in order to recoup some of the investment losses of earlier stages. The focus returns to the need to achieve a reasonable return, over a reasonable period of time, with a reasonable degree of risk. However, the investor will often come through the cycle with a different outlook on wealth management. For instance, this period in the cycle will often see the focus switch to wealth transfer by way of estate planning to minimise the effect of taxes on passing on their already depleted wealth.
For investors who retain strong wealth creation goals, the focus can shift to using different methods the second time around. Some investors may diversify their portfolios away from the single asset class focus e.g. the purchase of property as with many Irish investors in recent times. Others, sufficiently chastened by their experience, avoid all future investment opportunities in a particular asset class or geography altogether. This may turn out to be an over-reaction in the longer-term and result in a loss of opportunity when the recovery phase kicks in.
The recovery phase in the cycle is often the time when the long term experienced investor seeks to take advantage of the downturn in the market. Decreased share prices and dramatically reduced property values offer compelling buying opportunities for those investors who a) remain liquid, with adequate access to finance and b) have an appetite to adopt a medium / long term view on asset values and yields in the future.
Following a market correction the challenge to investors is to understand that the world has not ended and economic recovery will return to the markets. Now is a time to seek the opportunity to establish a diversified portfolio that will take a position in a number of different asset classes across a reasonably broad range of geographic markets and currencies. |
Paul Martin is head of wealth management, Bank of Scotland (Ireland).
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