Maintaining wealth in the early 21st century

Tim Cotton is a personal finance and investment adviser for Grant Thornton.

Entrepreneurs want to know why they should invest in the stock market and, if so, what are the options that are going to maintain the real value of their capital. Tim Cotton asks, will alternative investment provide the answer?

A common doubt among many entrepreneurs on selling a business is why they should reinvest any money in the stock market. We understand their point. Typically shares in a FTSE 100 company, over which the investor has absolutely no control, will cost more than 15 times this year's earnings. The sale of their own business on the other hand, over which they have exercised and sold complete control, is lucky to make ten times earnings. It doesn't sound like a good swap.

The same reluctance is shared by many ordinary investors, pension funds and insurance companies who, hurt by a savage three-year bear market from March 2000, still question the wisdom of share-based investments. And if a 52% fall from top to bottom is not enough discouragement, the developed world economies now face $50-a-barrel oil prices, a pensions-funding crisis, production migration to India and the Far East and global terrorism. It's enough to make even hardened investors reach for their building society pass-books. As they have in droves.

In the most recent quarter for which statistics are available (Q2 2004) UK private investors added a further £11.4 billion to their bank and building society accounts. Over the same period they added less than £1 billion to unit trusts and ISAs.

Clearly for many investors, earning interest at 5% a year with no apparent risk, the rate with which one leading internet bank newcomer is tempting new savers, is a better proposition than risking their capital on an uncertain stock market.

But the old rules still hold true: inflation will, over the long-term, erode the real value of any deposit-based investment. Take our internet-bank investor earning a comfortable 5% per annum. As he/she is a wealthy individual he/she pays 40% income tax on his/her interest, leaving him with a net return of 3% per annum. Better than nothing – until you deduct inflation, which in August (as measured by the Retail Price Index) rose to 3.2%. In real terms therefore our internet-bank investors deposit is falling by 0.2% per annum.

So what other options will maintain the real value of capital? To answer this many investors are turning to alternative investments such as private equity investments and hedge funds.

To take private equity investments, first of all, a distinction must be drawn between private equity and its close cousin, venture capital. Venture capital typically involves early stage investment in unproven business ventures and technologies and will often receive government incentives in the form of tax relief to compensate the investor for the high failure rate associated with such investments. For the private investor attracted to income tax relief of 40%, venture capital trusts are one means of investing in such ideas.

Private equity is an altogether different proposition and available only to institutional money and individuals who are able to invest £1 million plus with the managers who run private equity funds.

Private equity funds will invest in venture capital, but more usually they make their money from arranging and financing management buy-outs of established businesses and by buying companies from the stock market where traditional investors have lost interest. Their profits come from structuring complex financing arrangements, bringing in specialist management teams and by merging their investments into larger, more valuable organisations before selling them on.

The largest of these funds have serious financial weight. For instance, Apax Partners and Cinven, two of Europe's leading private equity fund managers, have just paid €2.1 billion for VNU World Directories, which publishes Yellow Pages in much of Europe, for their investors.

The returns from private equity funds are impressive. In 2003, it is said, private equity funds had outperformed all UK pension funds and all UK stock market indices over the previous 3-, 5- and 10-year periods. More importantly they made money for their investors in each of these periods although, as past performance is no guide to the future, there is no guarantee they will continue to do so.

But high entry hurdles aside, there are drawbacks to such investments for the private investor. Chief among these is that ultimately to make their money, private equity funds have to sell their investments. And because of the size of companies they are building, the stock market is the obvious answer. However lack of appetite among investors for new issues, and the fact that many of these businesses were bought from stock market investors in the first place, has reduced demand.

The funds have dealt with this to some extent by selling companies to each other. It remains to be seen whether there will be sufficient appetite for secondary buy-outs to keep the high returns going.

One type of investment which is not reliant on the level of the stock market is a hedge fund. Although hedge funds have been around for many years (Alfred Winslow Jones is credited with starting the first hedge fund in 1949) their availability has increased exponentially in the UK over the past five years, mainly because of a relaxation in stock lending rules.

The ability for a fund manager to borrow stock is fundamental to the hedge fund strategy as it allows him to run a trading book which consists of both long positions (shares which the manager owns) and short positions (shares the manager has borrowed and sold in the hope of buying them back cheaper at a later date). By running a book with both long and short positions, the astute hedge fund manager ought to be able to factor out general stock market risk and concentrate on the performance potential of his underlying stocks to produce a consistent absolute return with lower risk.

The strategy has worked well. For instance in 2002, when the S&P 500 index dropped 22%, the average hedge fund made a positive return of 3%. In 2003, when the S&P 500 rose 28%, the average hedge fund returned 15% .

But there are concerns that hedge funds have had their day. This year, as the industry has struggled to cope with huge inflows of money, returns have plateaued.

Although they aim to factor out market risk, hedge funds remain a high risk investment because they use leverage to increase investor returns. The potentially disastrous combination of borrowed money and complex trading strategies was no better demonstrated than in the collapse of Long-Term Capital Management, which had to be bailed out by the US Federal Reserve in 1998 with debts of $90 billion, after over-committing itself to a supposedly risk-free play between Russian debt and US Treasury bonds.

The industry is now much better at regulating itself and another LTCM is unlikely. Nevertheless investors in hedge funds should always bear in mind that hedge funds lie outside of the UK's regulatory regime and trust in the fund manager is the investor's only assurance that things won't go wrong.

So, do the risks associated with private equity and hedge funds make them unsuitable for all but the speculative investor? Probably not, as long as they occupy only part of a balanced portfolio and are chosen carefully. Because of the high entry hurdles, for most investors this means employing a fund of funds manager to look after their investments on their behalf. 

Investors must also accept that these are high risk investments which could lose a substantial proportion or even all their investment if things go wrong. In addition such investments place restrictions on when the investment can be realised.

So what else might tempt our investor away from the safety of his internet bank account? Firstly it is important for any investor to have a clear view of their investment goals and also to consult an appropriately qualified adviser before making any decisions. But many investors are realising that in a low inflationary environment, investment income rather than capital growth will be the driver for better returns.

This does mean higher portfolio allocations to income producing assets, which include bank deposits, as well as fixed income securities and commercial property. It may also include high yielding UK shares. Such asset classes should provide the investor with a steady 5–7% a year before tax and costs and although there is risk of capital loss, this should be relatively low. 

At the same time, the investor should look at committing smaller amounts of his portfolio to much higher risk investments, especially those that will benefit from some of those threats currently facing the developed economies. Commodities and developing market equity funds are two of the more obvious examples.

Such a portfolio might be invested up to 70% in lower risk income producing assets with as little as 30% committed to risk investments such as hedge funds, private equity and high risk investment funds. This would be quite a departure from the traditional buy-and-hold share-based portfolios which have dominated the UK retail market for the past 25 years. But who knows, they may even make some money.