Meet our Expert

Nandu_PatelNandu Patel – A Managing Director in Rothschild Wealth Management and Head of Charities

Nandu has more than 27 years’ experience in financial services. Nandu joined Rothschild in 2010 to develop its charity business. Nandu founded and remains a trustee of a grant making UK registered charity focused on education, health and relief of poverty in the UK, East Africa and the Indian sub-continent. 

 

“We have received a sum of money to be used to provide an educational bursary. The idea is to invest the money and use the interest to fund the bursary – but interest rates are so low (around 0.5% or thereabouts) and so it won’t go very far. Is there any way that we can achieve a higher return (ideally around 5%) without a huge risk?”

The answer

Many charities share similar investment objectives: to protect and grow the real value of their capital, and hence their real purchasing power, over time. At Rothschild, this is very much our focus and inflation is one of the major threats we are always trying to guard against.

Seeking an appropriate return with an acceptable level of risk is probably one of the most important questions that any investor, particularly a charity investor, can ask themselves. Risk is most often defined as volatility of return rather than permanent capital loss (which is another interpretation).

If they focused solely on risk, the lowest risk investors should, arguably, only invest in short dated government bonds and cash. Government bonds, or gilts as they are known when issued by the UK government, are considered to be the lowest risk of all investments. Cash is generally considered to be slightly higher on the risk spectrum as the likelihood of a bank folding is higher than the UK government, the recent financial crisis being a case in point. Despite the perceived lack of risk in holding UK gilts and cash, they currently offer very little in terms of yield or interest rate. While the volatility inherent in holding these investments is likely to be low, there is a big risk that purchasing power will be reduced as inflation erodes the value of the capital, which is not offset by the yield on the gilts or the interest rate on the cash.

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To get a higher return than that offered by short dated gilts or cash, it is necessary to take on some risk, in terms of volatility of return. To get a 5% return at today’s inflation rates (inflation plus 3%) implies taking on more equity or equity like risk. To target real returns (after inflation) in the current environment, it is necessary for an investor to invest in real assets such as equities, property, commodities and certain types of hedge funds.

Rothschild has modelled return expectations for the different asset classes over the next 7 years and those with the least potential volatility, usually regarded as the ‘safest’ asset classes, also delivered the lowest, or negative, real returns. The best chance of delivering real returns was found to be to investing in equity or equity like asset classes, but these also had the most potential for volatility.

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The right blend of high return high volatility and low return low volatility asset classes can achieve your desired return target and with risk that you are comfortable with. Let’s call this the ‘Rothschild Equity Risk Strategy’ for sake of argument.

We not believe a traditional asset allocation approach of 60% equities and 40% bonds will achieve what you want as this approach masks the true risks in a portfolio. The longer dated government bonds that often populate the bond portions of traditionally managed balanced portfolios can be responsible for big losses if bought at the wrong stage of the investment cycle. For example, between 1946 and 1974 10 year gilts lost clients 75% of the real value of their capital.

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Rothschild creates portfolios by making a formal distinction between and blending ‘return’ assets, which aim to deliver real capital growth over the long term by taking on more risk, and ‘diversifying’ assets, with low or negative correlation to equities or which aim to offset risks and reduce volatility, hopefully providing insurance or protection in the event of difficult equity market conditions.

Rothschild distinguishes between ‘return’ assets, which aim to deliver real capital growth over the long term by taking on more risk, and ‘diversifying’ assets, with low or negative correlation to equities (or which aim to offset risks and reduce volatility), hopefully providing insurance or protection in the event of difficult equity market conditions. We create portfolios by blending the two; the exact combination will be determined by your return objectives and risk tolerance.

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Using modelled expectations in terms of return and risk for a ‘Rothschild Equity Risk Strategy’ over the next 7 years (see the Table above), it is possible to compare the anticipated returns and risk from this approach to the return metrics of cash (2.0% annualised return and 2.1% volatility) or a short dated gilt portfolio (1.7% annualised return and 6.5% volatility) over the next 7 years*.

*Please note, modelling has limitations, is based on historic and index data rather than the individual securities or funds that make up real portfolios and cannot be relied on always as an accurate predictor of the future.

A higher than cash return is necessary just to keep pace with inflation and not taking on any risk in terms volatility will inevitably lead to an erosion of the purchasing power of capital. Our view is that in a low yielding and low return environment such as today, achieving even a modest 5% nominal return above that of cash or short dated gilts would require placing between 70% – 90% of a portfolio in return assets, thus taking on volatility risk.