Investments

Most investors instinctively feel comfortable investing in their domestic stock market. The FTSE100 index of leading UK shares is made up of familiar names, and within the largest quoted companies, investors can gain access to attractive dividend yields and modest valuations. The reality is, however, that investors in UK equities will have seen returns lag behind those achieved by their global counterparts over the medium term.

Diminishing influence

The story for 2024 has been all too familiar for UK equities. In the period from 1^st January to 30^th October – the day of the Budget speech – the FTSE100 index of UK shares produced a total return of 8.92%, compared to the S&P500 index of US shares, which returned 20.37% over the same period. The gap between the UK and US indices has widened further during November, as investors digested the impact of the Budget on the outlook for UK equities, and US shares enjoyed a boost from the clear Trump victory. Further evidence of a lack of investor confidence in the UK can be observed given the large outflows seen from UK equities in advance of the Budget.

The London Stock Exchange is one of the oldest known trading exchanges; however, the influence the UK can exert in a rapidly changing world is diminishing. Within the MSCI World Index, a composite index of the largest global companies, the UK now accounts for just 3.5% of the index weight, compared to 72% for the US.

The explosive growth in the largest US quoted companies has seen the market capitalisation of Apple, Nvidia and Microsoft all individually exceed the combined value of the largest 100 quoted companies in the UK.

One of the reasons for the lack of traction within UK equities is the absence of large-cap technology stocks. The market clamour for stocks involved in artificial intelligence and other high-growth areas has seen value equities, which offer solid cash flow and attractive dividend yields, fall out of favour. Indeed, the decision of British chip designer ARM Holdings, which decided to relist in New York rather than London, was further evidence that technology stocks that wish to gain wider investment exposure can do this more readily on the Nasdaq exchange.

Impact of the Budget on confidence

You could reasonably argue that the recent Budget has done little to boost the fortunes of domestic equities. Prior to the Budget speech, confidence in the prospects for the UK economy was already at a low point. Government ministers repeatedly warned of tough measures in the Finance Act and the Budget speech itself surprised many economists and commentators with the breadth of tax raised.

From a business perspective, additional costs from the hike in Employer’s National Insurance are likely to impact UK growth. Firms could look to trim expansion opportunities, or more likely pass the additional costs onto the consumer. Sectors such as leisure, hospitality and retail, where many workers receive the minimum wage, will see a direct increase in wage costs from April 2025, which will squeeze margins further.

This set of events have the potential to nudge inflation higher during 2025, and potentially force the Bank of England to re-shape the trajectory for UK interest rates. Whilst further rate cuts are expected, there is growing consensus that the pace and timing of the cuts may be slower than anticipated.

Consumer confidence remains weak, with the “cost of living” crisis still alive and kicking. The combination of mortgage rate resets for those coming off cheap fixed rate deals, higher energy costs and static tax bands, mean that consumers may shun big ticket items whilst focusing on essentials.

An improving outlook for the UK economy could increase investor appetite and boost the prospects for UK equities; however, the projected growth figures announced in the Budget suggest that GDP growth will remain subdued over the next five years. As a result, investors, who take a global approach to investment, may well look to other markets, where growth potential is more appealing.

Reasons to be cheerful

Given the current position, we have painted a rather negative picture of the prospects for both the UK economy and UK equities over the medium term. There are, however, reasons to invest in UK equities, particularly if the investor seeks a high level of dividend income. The current dividend yield on the FTSE100 is 3.70%, although companies offering yields well in excess of this level can be found. Seeking income from overseas investments can be more difficult, with the S&P500 index of US shares producing a dividend yield of just 1.19%.

UK equities are undoubtedly cheap when using certain metrics, with the FTSE100 standing at a considerable discount to the implied earnings growth of the S&P500 index. The UK also stands at a slight discount to Eurozone equities. Whilst you could argue that this suggests that the UK is attractively priced, it is entirely possible that the relative value on offer is by virtue of the modest outlook for growth. In other words, the UK could be “cheap for a reason”.

The UK still has a place

Despite the weaker outlook, it would be unwise to dismiss UK equities. We believe they command a place in a well-diversified investment portfolio, particularly for investors who are seeking income from equities, or value to counterbalance growth in a diversified approach. It would, however, be sensible to consider the composition of your investment portfolio, as holding excessive weights in the UK, without adequate global diversification, could limit the prospects for investment returns, and also introduce additional risk. Many traditional discretionary management services focus on UK equities, and we have seen examples where performance has lagged due to an overallocation to domestic positions.

Our experienced advisers can help review existing investment portfolios and provide independent advice on the current asset allocation, diversification and levels of risk. Speak to one of our advisers to discuss your portfolio in more detail.

Positive early reaction

In the immediate aftermath of the election, US equities saw strong trading, with the S&P500 index pushing through the 6,000 level for the first time. A factor boosting the short-term positivity may well be the absence of uncertainty over the election result, which brought about market volatility in the aftermath of the 2020 election.

Whilst equities have reacted positively, bond yields have risen, as investors flee from US Treasuries. This reaction is understandable, as the likely policies a second Trump term will bring, such as tax cuts and increased tariffs, may well be inflationary. This could undo the work of the Federal Reserve, who have been successful in reducing inflation, so that it rests just above the Federal Reserve target. Markets have been anticipating a series of US interest rate cuts during 2025, which would help support a slowing economy. Depending on the speed and size of expansionary plans laid out by the Trump administration, the pace of interest rate cuts could slow, meaning interest rates remain higher for longer. This impacts the US housing market and could weaken consumer confidence.

A second Trump term may well herald a series of tax cuts, including those borne by business. This could improve US corporate profitability and potentially support higher valuations. An extension to personal tax cuts introduced in 2017, which are due to expire next year, is likely, which could ease some of the cost-of-living pressures currently facing US households.

America first policies

Trump consistently proposed the introduction of international trade tariffs during his election campaign, to refocus on domestic production, employment, and growth.

The extent to which tariffs are imposed remains open to question, as some of the more extreme claims made prior to the election could simply be used as bargaining chips; however, any extension of import tariffs has the potential to drive the price of goods and services higher, leading to higher inflation and a possible fall in consumer confidence. Countries are, of course, able to retaliate by imposing their own tariffs on US goods and services, leading to a trade war. This could dampen global growth, and lead to further friction, particularly with countries with significant export markets, such as China.

It is possible that mid-sized and smaller US companies could see higher demand for domestic goods and services due to higher tariffs, although weakness in consumer confidence and higher prices could offset any benefit to US domestic suppliers.

Trump and global conflict

On balance, the second Trump term increases the potential for market volatility due to geopolitical instability. The World waits to see actions Trump could take in respect of the Russian invasion of Ukraine. Such decisions could have wider implications for the future of NATO and could see European nations increase spending on defence. Should the conflict end, this could well secure energy supplies going forward and remove the risk to potential supply shocks that caused market concern at the outset of the conflict.

Commodity prices may also be influenced by events in the Middle East. The ongoing tensions in the region have yet to cause significant concern to global equities and commodity markets over the course of this year; however, actions taken by the new administration could increase tension and any significant escalation could see oil production fall, potentially leading to higher prices.

Sector winners and losers

A range of sectors of the US economy are likely to be direct beneficiaries of policies introduced by the Trump administration, whilst others could face a more difficult future. Banks and Financials may well benefit from lower government regulation and red tape, and if US interest rates stay a little higher for longer, this could boost profitability. Oil and Gas producers may also be big winners, given the suggestions that Trump will look to expand US production. On the other hand, the renewable energy sector has already come under pressure since the election result, as Trump may well reduce tax credits and other incentives that have driven the boom in renewables across the US.

The largest US tech stocks have contributed a considerable proportion of the growth seen in US markets over the last year, and these tech giants have seen significant inflows at the expense of more traditional sectors of the economy. The difference in performance between high growth and value stocks has been clear, and this gap may well narrow following the US election result. The outcome may also benefit mid and smaller sized US companies, which have underperformed the mega-cap global giants.

Implications for portfolio asset allocation

In the wake of the US election result, equity markets have rallied on the expectation of corporate tax cuts and deregulation, coupled with relief that the election result was clear cut, without the uncertainty seen following the result in 2020. Treasury markets have given a less positive reaction to the Trump re-election. Given that policy decisions are likely to increase borrowing and fuel inflation, bonds have come under pressure, as inflationary fears have the potential to derail the Federal Reserve’s intended path for US interest rates.

2024 has proved fruitful for investors, and the outlook for 2025 appears robust; however, decisions taken by the second Trump administration in respect of both domestic and foreign policy may well increase volatility, as well as opening opportunities. As we head into more uncertainty, it would be an appropriate time to review existing investment portfolios to consider the asset allocation and strategy adopted. Speak to one of our experienced advisers to discuss your exposure to US equities and how the election result could impact market sentiment.

The success of any investment strategy is determined by the performance of the investments selected, and the length of time that the investments are held. Maths also plays an important part in contributing towards the returns achieved, as growth, which is accumulated or reinvested, benefits from a compounding effect, which helps accelerate investment returns over time.

In simple terms, compound returns are earned on both the capital investment and investment growth already achieved. This additional “growth on growth” has a cumulative effect and helps investments grow exponentially. Whilst incredibly powerful, the impact of compound investment returns reinforces the need to ensure that your investment funds perform well. If funds underperform over a sustained period, this can lead to substantially lower returns, when considering investment strategies that are in place for many years, such as a pension.

To demonstrate the impact of compound returns, take the example of Alice, whose pension plan is valued at £100,000. She plans to retire in 20 years’ time and does not expect to contribute further to this plan. If the investment achieves a rate of return of 3% per annum compound, the value at the end of the 20-year investment period would be £175,000. Increasing the investment return to 5% per annum compound would see the value at the end of the 20-year investment period increase to £252,000. Achieving an even higher return of 7% per annum compound would see the value at the end of the 20-year investment period rise significantly higher to £361,000.

As demonstrated on the graph, the rate of growth accelerates due to the impact of compound returns. By achieving compound returns of 7% per annum, rather than 3% per annum, at the end of the 20-year investment period, the value of Alice’s plan would stand at more than double the value that would have been achieved if returns were only 3% per annum.

This simple example demonstrates the power of compound returns; however, other real-world factors need to be considered. It is important to reflect on the eroding impact of inflation on investment returns, particularly over a longer timeframe, such as a working lifetime. The spending power of money falls over time, and this factor needs to be considered when undertaking calculations on future investment returns. The annual return achieved from risk assets, such as equities, bonds, and property, will also fluctuate from year to year, and examples using a fixed linear rate of return are unlikely to prove accurate. Finally, the impact of tax and charges on investment returns also need to be factored in.

Why performance needs to be reviewed

Given the cumulative effect of underperformance, it is important to keep any portfolio strategy and investment fund selection under close review. We often meet with new clients who have held the same investments within a pension, investment bond or Individual Savings Account (ISA) for an extended period, and in many cases, the performance of the portfolio held has lagged the performance of other funds investing in a similar portfolio of assets, with broadly the same level of investment risk.

This is particularly true when we undertake analysis of legacy investment products, which were purchased some time ago. The financial services industry is constantly evolving, and many historic investment products offer a limited range of investment options, which can hinder growth over the longer term. We often see other drawbacks with legacy products, such as high charges and exit penalties.

Taking an independent view of the universe of investment funds is, in our opinion, a vital component that helps drive investment returns. Products offered by restricted advisers tend to offer investors a limited menu of fund options from which to select, with many of the choices often limited to in-house investment funds. Whilst some of these funds may perform well compared to sector peers, it is often the case that we see sustained underperformance, the effect of which becomes more apparent over time due to the compounding effect. Even small marginal gains in performance can compound into a significant difference in outcome. For example, on an investment of £100,000 held over 40 years, a slight increase in return achieved, from 4% per annum to 4.5% per annum, would result in additional growth of over £94,000 being achieved (before the effect of charges and tax).

Compound returns are a powerful factor that is hard to ignore; however, investors need to give sufficient time for the compounding effect to impact investment returns, as the effect becomes more powerful, the longer an investment is in place. This is particularly true when long term regular savings, such as pension contributions made over many years, benefit from the power of compounding.

How to take advantage of compound returns

Compounding is a powerful driver of investment returns, and investors should be aware of the need to review their investment portfolio regularly, so that changes to underperforming assets can be made. As the examples have shown, even a small difference in performance over time can have a major impact. It would also be wise to consider investment product selection, as legacy investments can hinder growth over time due to limited fund choice and higher charges.

Speak to one of our experienced advisers to review your existing investment or pension plans. We can analyse investment performance and where appropriate recommend changes that aim to take full advantage of the power of compound returns.

It probably hasn’t escaped your notice that a range of taxes have increased over recent years, in part due to the economic effects of the pandemic. In March of this year, the Office for Budget Responsibility projected that 37.1p in every pound generated in the economy will be subject to tax by 2028. The date of the first Budget for the new Government has been set for 30^th October, and media speculation is rife, suggesting potential changes to tax legislation that could increase the overall level of tax take further.

As a result, tax-efficiency is high up the wish list for many investors. The most popular options to increase the tax-efficiency of an investment strategy is the use the annual Individual Savings Account (ISA) allowance, or make pension contributions, which qualify for tax relief. These popular choices are, however, only two of a range of options that investors can consider to reduce the level of tax they pay. Investors who are comfortable accepting higher levels of investment risk may wish to consider Venture Capital Trusts (VCTs), which have grown in popularity over recent years. A qualifying VCT investment can provide a helping hand to small and growing UK businesses, but can also reduce your Income Tax bill, and provide you with a tax-free income stream.

Tax benefits

VCTs were introduced in the Finance Act of 1995, to encourage investment into Britain’s small and entrepreneurial businesses. VCTs are collective investments, with a fixed number of shares in issue at any one time. There are restrictions in place to limit the type of investment that the VCT can make, without risking their qualifying status. These include a £15m limit on the gross assets of the investee company, which must also not have more than 250 employees. In addition, 80% of the holdings within a VCT must be invested in these qualifying assets.

VCTs raise money regularly via the issue of new shares. Purchase of new shares via an offer provides the investor with up-front Income Tax relief of 30% on qualifying investments. This tax relief is retained as long as the investment remains qualifying and is held by the investor for at least 5 years.

In addition to the Income Tax relief, dividends paid by the VCT are tax-free. Most VCTs aim to pay regular dividends, and some actively look to arrange special dividends, in addition to the regular dividend schedule, subject to the performance of the underlying investments within the VCT. Finally, any gains made on disposal of a VCT are also free from Capital Gains Tax.

The need to accept higher levels of risk

It is important to recognise that the Income Tax relief provided on investment in new shares is given as compensation for the investment risk taken when investing in a VCT. As only fledgling unquoted companies qualify for investment, investors need to be aware that individual companies could fail; however, VCT investment has helped a number of household names, such as Zoopla, Secret Escapes, Gousto and Graze, take the next step in their growth story.

Investors in VCTs also need to bear in mind that their investment may be difficult to sell, as there is a very limited primary market. As a result, most VCT managers set aside cash funds within their portfolio to permit share buybacks, where the VCT company buys back shares from investors. Such buybacks are usually set at a small discount to the prevailing net asset value of the underlying VCT portfolio, and larger and more established VCTs offer buyback opportunities regularly. That said, the availability of VCT buybacks is dependent on the trading performance of the VCT, and there is no guarantee that a buyback opportunity will be provided.

Choose the strategy wisely

Given the potential risks and range of outcomes from an individual investment made by a VCT, selecting a VCT with a portfolio approach is of key importance. Generalist VCTs usually invest in at least 20 companies, with many offering greater diversification across a wider range of positions.

There are other variables that can adjust the level of risk within the VCT portfolio. Investee companies that are already established can offer greater stability than those that are at an early stage in the growth cycle. By investing in companies across different sectors of the economy, VCT managers can try and avoid systemic risks affecting the portfolio. By their very nature, most VCT investments will be within companies involved in new technology or e-commerce; however, by adding industrial manufacturers, healthcare and leisure companies, greater diversification can be achieved.

Some VCT strategies add other investments into their portfolio, such as those quoted on the Alternative Investment Market (AIM). Whilst these investments are potentially more liquid, they remain smaller companies that still carry greater levels of investment risk.

Wide variance in performance

Analysing the performance of VCTs launched more than five years ago, shows a distinct variance in performance. Taking into account the initial Income Tax relief, dividends paid during the investment period, and the net asset value after five years, the best performing VCTs have produced an annualised rate of return of over 20% per annum, which is highly attractive; however, this strong performance is certainly not universal. There are a number of sizeable VCTs where the annualised rate of return achieved is between 6% and 8% per annum, which is barely above the level of Income Tax relief available on purchase. A handful of VCTs have fared even worse, losing money over the five year period, and eating into the Income Tax relief gained on investment.

Why advice is critical

Whilst the tax advantages are attractive, it is important to recognise that VCTs are a high risk investment, and should only be considered by investors who are willing to accept a significant risk of capital loss. Whilst many VCTs have produced strong returns over the long term, when factoring in the tax relief on investment and dividend income, others have performed poorly.

Given that this is a specialist market, we recommend seeking independent advice before considering any investment in VCTs, to assess whether a VCT investment is appropriate for your circumstances, needs and objectives.

Our independent advisers can provide you with unbiased and holistic advice to improve the tax efficiency of your investment portfolio, and the FAS Investment Committee has full access to independent expert research on available VCT offers. Speak to one of the team to start a conversation.

Any long term investment strategy will enter stormy waters from time to time, with the Covid-19 pandemic, Russian invasion of Ukraine and inflationary spiral amongst the factors that have made for a bumpy journey over recent years. Since last November, market conditions have felt considerably calmer, with investors enjoying a period of solid returns. Over recent trading sessions, however, the swell has picked up again, with volatility increasing across global equities markets.

Why have markets outperformed?

The gradual decline in inflation and prospect of easier monetary policy, corporate earnings reports that have largely beaten expectations, and stronger-than-expected economic data have proved the catalyst for the positive market conditions over the first half of this year.

After the hangover from the Covid-19 pandemic, and the Russian invasion of Ukraine, central banks around the World were forced to raise interest rates to head off an inflationary spiral. With inflationary pressures now easing, investors have been eagerly anticipating a change in direction from central banks, as rate cuts are generally perceived as being positive for both companies and consumers alike.

Corporate earnings have also supported the rally seen through the first half of the year. According to Factset, 78% of US quoted companies reported better than expected second quarter earnings, with earnings reports from technology giants reinforcing the positive market sentiment.

The final factor behind the strong performance had been the continued strength of the US economy. Investors have been increasingly hopeful that the Federal Reserve manage to steer a course where inflation moderates, without tipping the US economy into recession.

Reaching the pivot

Recent economic data has, however, stoked fears that central banks could have left their restrictive policies in place for too long. The European Central Bank cut rates by 0.25% in June, and the Bank of England followed suit this month. The Federal Reserve has been keen to ensure that inflation remains in check, and are yet to cut rates, potentially increasing the risk of recession.

Recent US unemployment data has been much weaker than expected, and market consensus now expects that the Federal Reserve may need to take more drastic measures over coming months, to avoid a stall in economic growth.

Where strong earnings reports propelled markets higher over the first half of the year, forward guidance from a handful of tech giants over recent weeks has painted a more mixed picture. The valuations on major tech players are somewhat challenging, and earnings disappointments are likely to weigh heavy on market sentiment.

Away from the tech sector, the first signs of a rotation into more traditional industries have emerged, and renewed focus on value and mid-cap stocks could be a dominant feature over the remainder of 2024.

Seeking value globally

Whilst the performance of US markets sets the tone for global equities, there are always regional variances that provide opportunities. The outlook for the UK remains modestly positive, with an improving picture for growth over coming quarters, and UK equities continue to look inexpensive when compared to global peers. European markets also remain mixed. French stocks remain under pressure due to recent political instability, and general sentiment not helped by tepid Eurozone growth figures.

After a strong start to the year, the Nikkei 225 index of Japanese stocks has seen significant volatility of late, largely due to the strength of the Yen against the Dollar and the impact this may have on exporters. Despite the sharp technical moves in recent trading sessions, Japanese stocks remain attractively valued.

Chinese equities have struggled over the first half of the year; however, there are increasing calls for further stimulus, with additional Government intervention to help boost economic growth becoming more likely. The continued weakness in the beleaguered property sector may however, keep any outperformance in check, at least in the short term.

Geopolitical risks remain

Perhaps the biggest risk to global markets is the outcome of the US election in November. Investors have been weighing up the potential impact of the Trump-Harris showdown with the withdrawal of President Biden closing the gap in the polls. Markets had priced in a convincing Trump victory over recent months; however, the early surge in support for Harris could lead to an increase in market volatility, should momentum for the Harris ticket be sustained as election day draws closer.

The election result is likely to have implications for the conflict between Russia and Ukraine, which remains an ongoing risk to global stability and commodity prices. The US election result will also dictate the future path of US-China relations, where trade tensions continue, and the ongoing threats over Taiwan remain.

Conflict between Israel and Gaza, and wider unrest in the region, have yet to have any material impact on market sentiment. Any wider escalation could, however, push oil prices higher, damaging global economic prospects and fuelling inflation. Any surge in prices could, however, be tempered by weaker global economic growth.

Bond rally to continue?

Weaker economic data over recent weeks has seen bond yields fall (which pushes bond prices higher), and with markets now expecting a series of rate cuts by Western central banks over the next 12 months, the outlook for bonds appears broadly positive. Bond investors will, however, need to consider credit quality, in the event that economic growth slows significantly. The additional yield offered by sub-investment grade bonds does not appear to offer sufficient additional return to compensate for the increased risk of an economic slowdown.

A broadly positive outlook

After enjoying a calm and positive first half of 2024, we have seen greater levels of volatility over recent weeks, and we expect this to continue through the remainder of this year. US equities continue to offer good value over the longer term, although the short-term performance may well be dominated by actions taken by the Federal Reserve. UK and European markets remain cheap when compared to the US, and any renewed focus on value equities could shrink the performance gap between the UK and US.

Diversification remains ever important, and whilst equities markets may see further volatility in the short term, holding an allocation to other asset classes can aid stability. After being adversely affected by the inflationary pressures of recent years, government and corporate bonds look attractively priced, given the monetary easing expected over the next few quarters. Lower interest rates may also prove positive for both commercial property and infrastructure investments, which have underperformed since 2022.

With more volatile conditions seemingly set to return, we feel this would be a sensible time to review the investment strategy within pension or investment accounts that you hold. Speak to one of our experienced advisers to discuss your existing portfolio strategy and consider whether any changes would be appropriate.

Commercial property has traditionally played an important role in portfolio diversification. Direct Property funds that invest in UK physical property assets, such as warehouses, office and industrial space, has traditionally found a place in many portfolio strategies, as it tends to produce consistent returns, that show little in the way of correlation with other assets, such as Equities (shares).

Challenging markets

It is fair to say that the commercial property sector has faced a number of challenges over recent years. Many property holdings experienced void periods during the Covid-19 lockdowns, with the office and retail sectors particularly badly affected. In the aftermath of the lockdowns, commercial property has, again, struggled to spark interest from investors due to the spike in inflation which led to the rapid increase in interest rates during 2022 and 2023. The graph below shows the performance of the Investment Association UK Direct Property sector over the last eight years. Consistent returns were enjoyed until the Covid-19 outbreak, and following a rapid recovery as the economy reopened, the sector has faced serious headwinds as inflation and interest rates climbed.

Improving outlook

There is, however, increasing evidence that the prospects for the commercial property sector are improving. The Bank of England appear ready to press ahead with the first of a number of base interest rate cuts in the coming months. This could well prove positive for commercial property assets, as the returns achieved from property investments are particularly sensitive to monetary policy decisions. As base rates fall, and inflation settles around the Bank of England’s target, the rental income received from commercial property becomes relatively more attractive.

Further evidence of the improvement in sentiment can be found in the Royal Institute of Chartered Surveyors (RICS) UK Commercial Property Monitor, published earlier this year. The RICS research indicated that demand for retail and office space – two of the sectors of the property market that have been hardest hit – had seen the first tentative signs of increased demand. Furthermore, there is growing confidence amongst those surveyed that rents will increase over coming months.

Liquidity issues

Aside from the pressures of lockdown and adverse monetary policy, collective funds investing in direct property have also had to face liquidity issues that first surfaced immediately after the Brexit decision to leave the EU in 2016, which led to increase demand from investors wishing to sell their investments. As direct property funds hold large bricks and mortar property investments, that cannot easily be realised, increased demand from investors at the time exhausted liquid funds, and as a result, leading commercial property funds managed by the likes of M&G, Janus Henderson and Legal & General closed their doors to withdrawals temporarily.

Most funds reopened after 2016, and could be traded without restrictions, until the Covid-19 pandemic caused a further round of suspensions and liquidity concerns. Several funds have limped on, but a number of leading players in the industry have taken the decision to wind-up their property funds. M&G announced the wind-up of their Property Portfolio last October, with the process ongoing. Janus Henderson sold their entire property portfolio to a single buyer in 2022 and repaid investors, and St James Place’s property fund remains gated since the decision was taken to suspend withdrawals in October 2023.

Evolving strategies

Despite the loss of a number of funds within the sector, investors can still select from a range of direct property funds; however, those that remain open typically hold a higher allocation to cash, to mitigate against liquidity concerns. One of the largest funds in the sector, Legal & General UK Property, has taken the decision to make more fundamental changes to their portfolio, and have asked shareholders’ permission to alter the asset allocation, in an attempt to provide adequate liquidity and avoid holding excessive levels of cash, which can dilute returns. The Legal & General fund will continue to hold direct property assets; however it will also aim to hold an equal allocation to Real Estate Investment Trusts (REITs). These are quoted companies that hold a portfolio of direct property, from retail parks to student accommodation. As the shares are quoted and actively traded on the London Stock Exchange, their inclusion should alleviate future concerns over liquidity.

Additional considerations

There are, however, significant differences between a REIT and a direct property unit trust, which investors need to consider carefully, as the introduction of REITs changes the risk profile of a commercial property fund.

Firstly, a REIT can borrow money to purchase securities. This leverage is not present with a direct property fund and does introduce additional risk. Secondly, the buying and selling price of a REIT may not reflect the value of the underlying property portfolio, and the shares can trade at a discount or premium to the underlying value of the portfolio. Currently, many REITs stand at a discount to their net assets, reflecting the difficult conditions seen over recent years; however, an improvement in the fortunes for the sector could see these discounts narrow.

Is a hybrid approach the answer?

We wait to see the response to the changes made to the Legal & General Property fund, and whether other property funds may consider similar changes to their portfolios. It is clear that the ongoing liquidity concerns have cast a shadow over the sector and any measures taken that remove barriers to investment should be seen as a positive step. Investors will, however, need to carefully consider the impact of any changes within the asset mix within property funds.

Diversification remains the key

Commercial Property investments have traditionally helped diversify investment portfolios, and the improving market outlook, together with changes being made within the sector to alleviate investor concerns, may see fund inflows improve. We always recommend that investors adopt a diversified approach to investment, and hold a precise mix of assets that match your objectives and tolerance to investment risk. This is where our experienced advisers can add significant value, by considering your exact circumstances to determine the correct asset allocation for your investment or pension portfolio. Speak to one of our independent advisers to start a conversation.

After a decade of rapid growth, China has offered scant reward for investors since 2021. Where developed western markets have enjoyed strong returns since November, Chinese Equities continue to forge a contrarian path lower, despite a growing number of reasons why China appears to offer good value to investors. The graph below demonstrates the very different performance of the CSI China 300 index (shown in blue) compared to the S&P500 index of leading US companies (shown in red), priced in Sterling, over the last 3 years.

We take a look at some of the factors that have led to the underperformance, and outline reasons why we feel an allocation to China deserves a place in a diversified portfolio.

Continued growth

The Chinese economy has traditionally expanded at a rapid pace, with annualised growth of between 6% and 10% per annum achieved between 2010 and 2019¹; however, the rate of growth on an annualised basis has slowed over recent years. Covid-19 caused Gross Domestic Product (GDP) growth to dip, as was the case across the World, although the Chinese economy rebounded last year, growing by 5.24%. This rate of growth compares favourably to the US, which itself expanded by an impressive 3.1%, and very appealing when you consider the meagre growth achieved by the UK and Eurozone last year. Although the rate of growth predicted for the Chinese economy over the next five years is lower than pre-Covid levels, economists predict an annualised growth rate of around 4% per annum, which may well look attractive when compared to other leading economies.

Consumer recovery overdue

The Covid-19 pandemic was particularly damaging to the Chinese economy. Harsh lockdown rules capped economic activity to a large extent, and when the restrictions were eased in November 2022, economists expected a rapid acceleration and recovery, as domestic consumption rebounded and consumers spent money saved during the pandemic.

The reality has been very different to expectations, as consumer confidence remained stubbornly weak post-pandemic.  Very recent data has, however, indicated a slight improvement, with retail sales for May growing by 3.7% year on year², reversing the downward trend seen over recent months.

The need to reflate

Most western economies struggled to contain spiralling inflation during 2022 and 2023, caused by increased demand for goods and services post pandemic, and the impact of war between Russia and Ukraine, which pushed commodity prices higher. Given the sluggish recovery in consumer confidence seen in China, inflation was barely positive for 2023, and the International Monetary Fund (IMF) predict Chinese inflation will only reach 1% this year.

Beijing has already taken measures in an attempt to stimulate demand, such as offering trade-in subsidies against the purchase of new cars and white goods, and cutting base interest rates late in 2023. It is likely, however, that further monetary stimulus will be needed, which could prove a fillip for investors.

Unemployment levels amongst young people also remains a concern, with 14.2% of those aged 16 to 24, who are not in full time education, looking for work². That being said, this has steadily fallen from the 20% level seen last year, and we expect to see further measures to boost productivity and employment prospects, in particular in areas such as technology.

Property Market woes

One key reason behind the underperformance of Chinese Equities since 2021 has been the continued struggles seen in the real estate sector. Land and Property development, which according to analysts accounted for almost one third of China’s GDP at one point, boomed during the last decade, with much of the growth fuelled by debt. Overdevelopment saw a glut of unsold properties, spawning ghost cities amidst a buyers strike. Lack of consumer confidence in the wake of the pandemic, and demographic shifts are often cited as the key reasons for the extended slump in real estate prices.

As demand eased, and debts mounted, pressure began to bear on the largest property enterprises. Evergrande, a key player in the Chinese property market and at one point the most valuable property company in the World, defaulted on its debt in 2021, and eventually filed for bankruptcy in August 2023. Country Garden, another leading property firm, saw its shares suspended earlier this year. The company has also defaulted on loans and is facing a liquidation petition.

Concerns over the impact that defaults could have on the strength of local and national banks remain,  although the immediate prospects of a property-led banking crisis now appear less likely. China’s Government have announced a raft of measures in an attempt to arrest the decline, including the purchase of unsold homes by local authorities, although further action will almost certainly be needed to help boost confidence in the sector. Any such moves would be welcome; however, we expect the property sector to be a drag on growth for some time to come.

Transition to tech

The increased focus on new industry, such as electric vehicles, is a good example where Chinese companies have the potential to dominate global supply. A slow but steady move towards net zero will require change on a colossal scale, and a gradual move away from traditional manufacturing to added value could halt the decline in industrial production seen over recent years.

Good value for the patient investor

The poor performance of Chinese Equities since 2021 has led to valuations becoming increasingly cheap when compared to other developed markets. Estimates of the forward price to earnings ratio suggest that the MSCI China Index stands at between 11 and 13 times earnings, which is roughly the same level of market valuation as the UK, despite the fact that China is likely to grow their economy at more than double the pace of the UK over the next five years.

Despite the apparent inherent value, investment in China is not without risks. Continued pressure from the ailing property sector, ongoing tensions with the West and the potential for regulatory interference temper our enthusiasm, and given the outflows seen from Chinese Equities over the past two years, investment at this point would be considered a contrarian move.

Taking all factors into consideration, we see the potential for a rebound in the fortunes of Chinese Equities over the medium term. Investors will, however, need to show patience, and volatility may well be uncomfortable at times. We therefore feel that an allocation to China could be appropriate; however it is important to hold a diversified portfolio of assets, and our experienced team can provide advice to tailor your portfolio to suit your tolerance to investment risk, whilst ensuring diversification is maintained. Speak to us to start a conversation about the asset allocation within your investment or pension portfolio.

Sources

1 World Bank Group

2 National Bureau of Statistics of China

First available to investors in 1975, a passive fund aims to offer a low-cost method of replicating the performance of a specific market index, rather than actively selecting individual assets within a particular market. Over the last decade, passives have grown substantially in popularity, with Morningstar research confirming that passive funds saw higher inflows than active funds during 2023.

The rise in the popularity of passive strategies is also evident from our own market analysis. Our Investment Committee regularly undertakes a comprehensive review of managed portfolio solutions offered by discretionary fund managers, to ensure that we can demonstrate that FAS clients receive good value for money. Our analysis clearly demonstrates an increasing bias towards passive investments, on which many of our competitors’ products and services are founded.

The rationale behind the increased use of passive investment funds is that the ongoing cost of a passive investment is usually cheaper than an actively managed fund. This helps passive only strategies maintain a competitive total cost of ownership. A key drawback of such an approach is that investors may be missing out on additional returns generated by strong active management. In our opinion, many portfolio managers are confusing “value for money” with “cheap”, with the focus on costs being the dominant factor.

Drawbacks of passives

Many investors fail to take account of two key disadvantages of a pure passive investment approach. The first is that, by definition, a passive investment will not outperform the representative index or market it is trying to replicate. Indeed, due to costs and potential tracking errors, most passives return just below the index return. As an investor, we contend that you should be seeking outperformance where possible, as long as the level of risk being taken remains commensurate with the prospects for superior returns.

A second key risk of a pure passive approach is that replicating an index will mean producing returns in line with that index. When market indices fall, the value of a passive investment tracking that index will fall by a similar amount. Unlike a fund with an active manager, who could potentially take avoiding action by reducing allocations, increasing the percentage of cash or possibly using derivatives, the passive fund will simply track the index on the way down.

Our approach

Within our investment strategies, we try to seek out good value for our clients, and our independent status allows us to take an unbiased approach as to the precise blend of funds we select. This allows us to select passive funds, where this is appropriate. We will, however, also look to use active funds if we feel this is likely to result in outperformance.

Our Investment Committee undertake considerable research on a sector and region basis when conducting the regular review of funds that we recommend to clients. This research, which has been carried out for many years, allows us to better understand areas where passive investment is likely to be sensible, and where selecting an active investment approach may produce superior returns.

The most commonly cited example of a sector where passive investments perform well is US Equities. Our own analysis has shown that index funds that track the S&P500 index of leading US companies tend to produce consistently strong returns when compared to actively managed US Equity funds. There will, of course, be active funds that do beat the market; however, the key is whether this can be achieved on a consistent basis.

One of the main reasons for the attractiveness of passive funds in US markets is the dominance of a small number of mega-cap stocks, where performance has been positive compared to the wider index for some time. Our analysis concurs with research carried out by S&P Dow Jones, who suggest in their recent SPIVA report that 60% of active large-cap US Equity funds failed to beat the representative S&P500 index during 2023.

A good example of an area where passive investment has shown historic weakness is in Fixed Income investment. Whilst many investors would associate passive funds with Equity investment, a wide range of passive bond funds are now available, which track a particular UK or Global bond index, and typically replicate hundreds or potentially thousands of individual bond positions. Bond investment is an area where adopting the correct strategy can yield significant outperformance, and an active bond fund manager can alter the duration of bonds held, the credit quality and sector or geographic allocation, to try and generate superior returns over the benchmark index. These additional levers available, which can adjust the allocation within the fund, can help a skilled fund manager generate superior performance to a passive fund, which simply holds the constituents of an index.

At FAS, we view ourselves as conviction investors, and therefore when selecting an active fund, we prefer to select an investment manager or team with a clear vision as to how their fund is to be positioned. This can often mean a concentrated portfolio, when compared to the representative region or universe of stocks available. All too often, we come across funds that employ an active manager or management team, who take an approach that allocates their portfolio closely to the benchmark index. In most instances, such funds fall between two stools, carrying high charges without the prospects for outperformance.

Summary

With the increased focus on costs across the industry, many portfolio management services are leaning towards a passive only investment approach, with the ultimate aim of highlighting a competitive pricing structure. We feel such an approach is highly inflexible and potentially means that opportunities for outperformance from active managers is being missed. We prefer adopting a hybrid strategy, using passive funds in areas where index tracking funds should perform well, combined with actively managed funds where we feel the prospects for outperformance justify the higher costs of active management.

If your investment manager is using a passive only approach, speak to one of our experienced advisers to discuss whether adopting a different strategy would be appropriate.

Recent events in the Middle East have once again led to increased concerns about the impact that World events can exert on global financial markets. In such times, it is important to remain focused on the long-term trend, and to try and avoid taking short-term decisions that could prove detrimental, as history tells us that the initial knee-jerk reaction to global events is often short lived.

Why markets react to conflict

It is true to say that investment markets crave certainty at all times. Calm waters allow investors to focus on the prospects for the global economy and individual companies, without the need to consider the disruptive impact of global events, such as major conflict. One of the key reasons why recent conflicts have caused consternation from an investment perspective is the potential impact on commodity prices. For example, as Middle Eastern nations are key players in the global oil market, the recent heightened tension between Israel and Iran have forced oil prices higher. Likewise, the Russian invasion of Ukraine caused a significant spike in natural gas prices due to supply shortages.

What history tells us

Looking back through history provides clear evidence that investor pain following a global event is relatively short-lived. The Russian invasion of Ukraine in February 2022 led global markets lower, as inflationary pressure rapidly increased and caused investors to re-think economic projections. Despite reacting calmly to the initial outbreak of hostilities, the S&P500 index of leading US stocks moved decisively lower a few weeks later, and took just over one year to recover to a higher level than at the start of the Russian invasion. For those investors who correctly took the view that investment is a long-term process, this period of uncertainty will now be little more than a memory, as the S&P500 now sits relatively close to new all-time highs.

Other major conflicts and acts of terrorism have caused a sharper short-term market reaction,  which then quickly corrects once markets have had time to assess the impact. Following the suspension of global markets in the wake of 9/11 attacks in 2001, the S&P500 index fell over 11% in the space of seven trading sessions, as investors digested the US reaction and potential impact on economic prospects. The downturn was, however, very short-lived, as by October 12^th 2001, the S&P500 had recovered the ground lost immediately following the terror attack and ended the year a further 5% higher.

It’s not just war

Of course, geopolitical risk does not necessarily increase as a result of conflict. The outbreak of the Covid-19 pandemic created the largest global economic crisis for a generation, as lockdowns caused significant damage to public finances and global commerce. Between April and June 2020, UK Gross Domestic Product fell by a record 19.4% during this period, only to rebound by 17.6% in the following three months, as the country slowly emerged from the first wave of lockdowns.

Investors had nowhere to hide during the early stages of the pandemic, with stock markets around the World moving rapidly lower during March and April 2020. The S&P500 index fell by 29% from 1^st January 2020 to the low point on 23^rd March 2020, but had recovered to stand higher than at the start of the year by the end of July, just four months later.

Many investors will vividly recall the unprecedented sense of concern at the time of the Covid-19 outbreak, and the economic damage to public finances around the World will take many years to repair. Global Equities markets, however, corrected rapidly once the initial panic had subsided and investors began looking at the fundamental recovery in business confidence and economic performance to follow.

Climate related events also have the potential to be a greater source of concern to investors over years to come. The changing weather patterns and increase in extreme weather events have the potential to reduce economic output and cause widespread damage, including disruption to supplies of raw materials, food and energy. Our view is that climate related risk may also prove to be an opportunity for those industries who are able to adapt, and the impact of such changes could be far more gradual over a number of years than the immediate impact of conflict or other global events.

Why markets bounce back

As demonstrated by recent precedents, global markets tend to be resilient and often shrug off an initial overreaction to unexpected global events. Once the initial shock of the event has subsided, investors are able to take a measured view of the impact on corporate earnings and economic growth, with markets often rebounding quickly following an initial sell-off. One of the primary reasons why this may be the case is that central banks can invoke a monetary policy response, and Governments can provide fiscal stimulus, which can boost investor confidence. It is also often the case that the global event will do little to damage future earnings, although of course depending on the nature of the event, some sectors of the economy may be more adversely affected than others.

Keep the long-term view in mind

When investing in Equities, it is vital to focus on the longer term objectives. Equity markets are volatile, and from time to time, global events push risk levels higher and can cause periods of underperformance. Whilst we cannot predict the future, we can learn from the market’s reaction to past events, and it is evident that markets often rebound shortly after the initial shock of a global event has passed. Even a once in a generation event (we hope…) such as the Covid-19 pandemic, only caused markets to retreat temporarily. Comparing index values today to the depressed levels seen in March 2020, is a potent reminder of the need to stay calm and stay invested through turbulent times.

It is at times of major concern that the ongoing advice of an independent financial adviser can prove invaluable, both to provide counsel on actions that need to be taken and reassure and aid you to focus on the longer term prospects. Our advisers at FAS are highly experienced, and through regular contact with clients, can provide ongoing advice in all market conditions. Speak to one of our friendly team to start a conversation about your financial planning requirements.

For many years, Japan has been considered as “tomorrow’s story”, where there is much promise, but returns disappoint. That is until this year, where the Japanese Equities market has shown considerable strength. There is good evidence to support further outperformance; however, investors would be well advised to look to the past to understand why Japanese markets have struggled over an extended period, and the steps that policy makers need to take to avoid treading a similar path in the future.

Learning from history

The Japanese stock market has endured over 30 years of underperformance, following a significant economic bubble that formed in the late 1980s. At the time, Japan was growing more rapidly than many Western economies, and spurred on by lax monetary policy and growing investor appetite,  the Nikkei 225 – the most widely reported stock index in Japan – increased from an index value of 13,000 in 1985 to reach a high of 38,915 in December 1989. Across the board, asset prices rose, with the bubble spreading to other asset classes, such as real estate, where values of stocks and property reached overly optimistic levels of valuation.

Asset bubbles tend to end in a disorderly manner, and following the boom, the Nikkei 225 fell heavily in the early 1990’s. Following rapid acceleration during the previous decade, the Japanese economy moved into an extended period of low growth, due to the lingering effects of the asset bubble. The Bank of Japan moved to reduce interest rates to near zero, a level at which rates have broadly stayed ever since, in an attempt to reignite economic growth.

Economics and demographics

One of the reasons why Japan’s economic performance has been an outlier, when compared to other Western economies, are the demographics of the Japanese society. Population levels in Japan are in decline, and the World Economic Forum reports that more than 1 in 10 people in Japan is aged over 80. This has helped keep a lid on domestic consumer demand and there has been a tendency for the population to save, and not spend, despite receiving little in the way of interest. As the population ages, those in working age could see wages increase, leaving consumers with more money in their pockets to spend.

Deflation has been a constant threat that the Bank of Japan have had to deal with. Elevated inflation around the World has been seen as an enemy over the last two years, and whilst high levels of inflation generally harm economic prospects, extended periods of zero inflation, or deflation, have a similar negative effect.

The last year has, however, seen a change in fortune for the Japanese economy. Partly due to the global effects of the pandemic, Japan has seen the first significant bout of inflation for decades, with inflation rising from close to zero in early 2022 to reach 4.3% in January of this year. Whilst inflation has now moderated to stand at 3% in September, the return of meaningful inflation is welcome news and may see domestic demand increase and consumer confidence grow.

Regulatory reform

In addition to the welcome return of modest levels of inflation, Japan is embarking on a number of initiatives to boost investor demand. Traditionally, Japanese companies have been keen to hold large amounts of cash on their balance sheets, and regulators have announced measures to encourage these companies to return funds to shareholders, in the form of increased dividends or share buybacks. There have also been announcements improving the tax breaks offered to encourage Japanese households to move away from traditional cash savings and invest in their economy through share ownership.

Valuations are attractive

When using recognised metrics, Japanese Equities appear to be attractively valued when compared to most other global markets. This may well see a spark in overseas buyer interest, after many years where investors have been reluctant to hold significant allocations to Japan. Indeed, Wall Street veteran Warren Buffett’s announcement that he intends to increase allocations to Japan in April was seen by some as an endorsement of the value in Japanese Equities.

Artificial Intelligence and advanced manufacturing have been drivers of global markets over the last 12 months, and Japan is well placed to benefit from the quest to achieve further automation of human tasks, given the nation’s strong history in areas such as robotics. Japan also has a number of companies who provide solutions that can meet demand for a more energy-efficient and greener future, such as Toyota and Honda.

The importance of diversification

There are several reasons that support the view that Japanese Equities look attractive; however, risks do remain, and whilst the regulatory reforms may prove helpful, there is still significant pressure on central bankers to steer a successful course as inflation slows around the World. This is why we recommend allocations to Japan are held as part of a diversified investment portfolio, which is an important method of controlling investment risk. Allocating funds to different regions, where performance does not necessarily correlate, and to different asset classes – such as Government and Corporate Bonds and Alternative Investments – can help reduce overall portfolio volatility.

Speak to one of our experienced financial planners to discuss the asset allocation of your portfolio.