The Real Conundrum: How to Position Portfolios for Real Growth

By Stephen Black (Managing Director at Tier One Capital) 13 March 2013

The main role of any wealth management company is to maintain and grow wealth. As much as this is complemented by other aspects of our proposition, which assist in the enjoyment and philanthropic distribution of wealth, the core focus of any wealth management company is, and always will be, to ensure that clients have confidence that this basic goal is being achieved and that their wealth is maintaining itself quite nicely. Fortunately, we have been afforded the luxury of a number of months with which to consider our answer to this fundamental concern whilst we have completed our FSA authorisation process. In decidedly unfortunate contrast to this, the markets over this period have risen strongly with a growth rate that seemingly indicates all’s well in the world. If we take it as red that the fact that the Bank of England are seriously considering implementation of negative interest rates is indicative of a less than optimistic outlook, then we can start to see a flaw in the market upturn and a real conundrum emerges.

As discussed in our last post, the average returns that are currently being generated by a cash portfolio are not keeping pace with inflation. In this way, maintaining the real value of money, whether held on instant access or over five years, is not currently possible (especially so after tax). To rub yet more salt into the wound, the suggestion that the UK base rate may become negative for the first time ever in over 300 years of interest rate records is a strategy which would, if actually implemented, undoubtedly cut the average cash rates yet further below an inflation rate which is slowly rising. Economically, such a situation in which we see high/growing inflation coupled with low/reducing productivity is termed a period of ‘stagflation’. While this term is currently not being widely used, all of us are going to become acutely familiar with this term over the next few years. It’s a wickedly difficult thing to shift once it sets in and serves to destroy the real value of wealth at a noticeable pace. Many will experience a micro-economic version of this as the returns from their capital struggle to keep pace with the simple maintenance of their lifestyle. This leads them to start using up additional capital to maintain their prevailing lifestyle and as the remaining lower capital level generates less income the problem self-perpetuates ever more quickly. The answer as to how to overcome this lies in logically assessing the options.

If we know for certain that the real value of capital is going to decline in cash we either accept this fact - and try to minimize this known real loss by maximizing the returns from a cash portfolio - or we try something different in order to avoid this. The ‘something different’ requires us to seek out something able to potentially outperform the inflation rate. If we assume that a certain portion of capital will always be held in cash for liquidity purposes then we can again narrow our target down further to source ‘something different’ that will potentially outperform the inflation rate by at least enough to offset the underperformance from the cash part of the portfolio. For clients simply looking to maintain or moderately enhance the real value of their wealth, this isn’t an insurmountable task as we can utilise investments such as structured deposits (which are covered by the FSCS) and potentially some relatively defensive versions of the riskier option provided by structured products (which aren’t covered by the FSCS).

A well-constructed portfolio sub-comprised of a portion in cash, structured deposits and defensive structured products certainly looks well positioned to achieve the current inflation hurdle rates of CPI at 2.7% and RPI at 3.3%. Furthermore, a good case can be made to add to this position with a multi-asset portfolio to give uncapped exposure to any upside of the markets for those unaffected by committing their capital over the longer term. A multi-asset portfolio will bring with it dividends and simply locking in the dividend yield on the FTSE 100 in a cost efficient manner is another option that compares favourably to simply holding cash at present in our quest to protect the real value of wealth. Not needing access to the capital in the short term means the potential for short term volatility will likely be made redundant over a medium to long term investment time horizon.

All in all though, the good news is that there are indeed viable options out there to maintain and enhance the real value of capital and as long as this is happening then you can rest assured that your wealth is going in the right direction.