The NURS effect on multi-manager funds

In October 1991 they changed the rules on fund of fund unit trusts so that one could buy underlying funds at ‘best’ rather than at creation.  This was a massive change which let the multi-manager genie out of the bottle and, as they say, the rest is history. 

 I was fortunate in being a private client fund manager at the time and had already rearranged most clients’ portfolios into one or more ‘models’ which, in those steam-driven days, we controlled by spreadsheet.  The new rules meant that we could establish a number of new fund of funds unit trusts to replicate our models and conveniently share-exchange most of our clients into them.  This made a huge difference both in our ability to manage actively and to put aside any previous worries about creating CGT liabilities for clients as a result of our active management.

 There was a major drawback, however, as far as I was concerned.  Many of our models (remember this was 1991) had previously included direct Gilt holdings which we bought for individual clients within their portfolios.  This was because it was easier to control individual Gift holdings and their yields than if one bought into what were, in any case, rather expensive Gilt unit trusts.  We had no choice once we had moved to fund of funds because each unit trust was either designated as a securities fund – which could buy individual equities and Gilts – or a fund of funds – which could only buy other funds (including Gilt trusts but not Gilts directly).

 A couple of years ago there was a long overdue and massive change to the regulation of collective funds within the UK with the introduction of UCITS 3 and, in the context of asset allocation, the introduction of NURS (non-UCITS retail schemes).  Many funds launched in the last couple of years have been launched as NURS schemes and several other pre-existing funds have been converted into NURS.  The benefits of NURS within multi-management are absolutely legion, especially as fund management becomes more sophisticated and new and slightly esoteric investment opportunities unfold.

 It is now possible to mix all sorts of asset classes and types within the same fund so that both risk and reward can be enhanced by blending the most contemporary of investment vehicles.  A NURS fund can invest up to 20% in a mix of unapproved securities and unregulated collective investment schemes (including hedge funds).  It can have permanent borrowings of up to 10% permitting a minor level of gearing.  It can comprise larger holdings both of individual securities and of collectives.  Importantly it can invest in property and gold.

 These possibilities open all sorts of doors for the professional manager and as a result many fund of fund managers are choosing to switch their multi-manager portfolios to NURS rules.  This allows them so much more freedom to mix and match investment types and include absolute return funds, structured products, bricks and mortar, funds from strange or specialist jurisdictions as well as commodities. 

 NURS rules permit managers to select funds which are managed very precisely by objective or within very esoteric areas, such as oil exploration or particular commodities.  Funds such as these are frequently closed-ended funds (often investment trusts) which allow their own managers to drive longer term strategies without having to worry about their capital base shrinking or expanding through outflows or inflows of shareholder money.

 A major attraction of closed ended funds is their tendency to fluctuate between discounts and premiums (being under or over valued) depending on market movements.  Often a manager of a multi-manager fund can pick up shares in an investment trust very cheaply where both the sector and thereby the trust are under-valued.  When there is a recovery there is likely to be a double rise enjoyed as both the sector and the fund move northwards.

 Because of the flexibility within NURS and the increased choice and complexity of options available to managers and, particularly, to multi-managers, there is a far greater degree of skill and experience which must be brought to bear.  This is why returns from well run multi-manager portfolios, which have always tended to be superior to single manager funds within each relevant sector, are becoming ever more competitive.

 There has always been a strong case for multi-management in achieving economies of scale, tax-efficiency, wider diversification, lower risk and higher returns, compared with running individual portfolios of shares or collectives.  But the recent emergence of highly sophisticated asset blending with judicious use of derivatives and other contemporary vehicles, following the introduction of NURS rules, means that the performance gap between old style collectives and new style funds is likely to increase even further as time goes by.

 This differentiation has brought multi-manager investing to new levels of sophistication.  Nowhere is this more obvious than within the Cautious Sector where managers can now incorporate absolute return funds, guaranteed funds and property funds into the mix to reduce both volatility and the degree of correlation between cautious funds and the equity markets.  It is time for investors to re-evaluate the quality of NURS funds operating within the Cautious Sector.

 One of the great difficulties is the preoccupation within the market place for looking at performance tables.  Many truly cautious funds, such as WAY’s own, have a benchmark equity weighting of some 30% against an IMA benchmark for the cautious managed sector of “up to 60%”.  This means that these more cautious funds will always under-perform the sector during bull market conditions because they have far less of an allocation to the single asset class which is going like an express train. 

 One has to ask whether a portfolio which contains 60% equities can reasonably be described as cautious.  To my mind we are still operating in sectors based on investment considerations from the last century.  In today’s markets there is much greater sophistication.  When one currently talks of caution we are not talking about focusing on high income equities or simply reducing the equity allocation by a few per cent, we are talking about a well-diversified portfolio containing a range of asset classes including property, absolute and guaranteed funds.  These will deliver lower volatility and robust cautious performance but they will not deliver 60% of equity performance!  Whilst the IMA Cautious Sector is full of equity income funds earning star ratings, the genuinely cautious funds will get little credit for the wonderful job many of them do for their cautious unitholders.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 15th October, 2007 |
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Going the extra mile

What differentiates an IFA from the crowd, what allows him/her to demonstrate TCF, what proves to the Revenue that a trust is genuine and not merely an artifice which requires no trustee input?  One answer to all these questions can easily be that the IFA recommends a flexible trust solution for IHT mitigation purposes rather than the simple but completely inflexible expedient of a discounted gift trust.

 By recommending a discounted gift trust an IFA is very likely helping the client to avoid either a little (if they live less than 7 years) or a lot (if they survive 7 years) of Inheritance Tax.  This is terrific so long as the client does not have too much reliance on the funds within the trust, especially if his or her circumstances were to change.  Unfortunately, however, to make a serious impact on the potential IHT bill one often has to shift substantial sums out of one’s estate and to do so every 7 years to repeatedly utilise the Nil Rate Band.  In these circumstances one really cannot afford to put the funds into Purdah for the rest of one’s life.

 They do say that men retiring at 60 will probably live until they are 85.  This gives the 60 year old retiree at least 3 stabs at the IHT Nil Rate Band.  Bearing in mind that I am fast approaching the first of those ages myself, it is sobering to think about how the lives of some of my friends within my peer group have changed very dramatically without warning in these later years.  Do the exercise yourself and you will know what I mean.  In my own case I have been ‘best man’ on two occasions for close friends and neither survived to see 60.  A further number of both sexes have become widowed and remarried.  In other cases serious illness has inflicted itself on the family.  Other friends again have had to bail their children out of failing business ventures or bad marriages.

In all of these cases they have needed flexible access to some or most of their money.  This is fine whilst it is in their estate and vulnerable to IHT but impossible if it is tied up in a discounted gift trust.  Having a fixed ‘income’ and no access to capital at all for anyone, regardless of their needs, is not great.

 The Flexible Trust route for IHT mitigation does not offer any discounts on the gift but that can be remedied with a little 7 year term assurance.  What the flexible route does do is make the trust very real because the trustees are obliged to make annual decisions on settlor reversions and loans or appointments to beneficiaries.  The scope for Revenue attack on the basis of artificiality is absent.  It also means that the advising IFA has demonstrably put the client first and is treating him or her incredibly fairly.  Finally it will almost certainly mean that the IFA is not simply replacing an IHT liability with an Income Tax liability – something which generally happens with a discounted gift trust – but is mitigating all taxes.

 So, my challenge to all IFAs out there is to ‘step up’ and show your professionalism by going the extra mile and switch your allegiance to flexible IHT trusts.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 30th August, 2007 |
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Treasury delighted – it’s the ISA season again

The annual ISA momentum is building.  Our doormats are dancing to the impact of ISA circulars from any and every financial institution we have ever dealt with and many others with which we haven’t.  The effort of selling ISAs to clients each year and the danger of selecting what turns out to be inappropriate funds, all for very little reward, means that many advisers leave the annual ISA scrum to the direct sellers.  However, there is every good reason for advisers to revisit this whole scenario and do themselves, their clients and companies like WAY an enormous favour. 

Who benefits from ISAs?
By stealth tactics the Treasury is misleading investors into thinking there are substantial tax benefits in retaining PEP and ISA portfolios into one’s dotage, while simply ensuring that it can continue to collect large amounts of IHT from the unwitting and unprepared elderly investor.  I believe investors from their mid-sixties onwards who believe they will have an IHT liability should no longer be investing in or holding PEPs and ISAs.  What so many of them do not realise is that they will suffer a punitive IHT sting at death, whereby they and their families potentially lose a colossal 40% of their hard-earned savings.  This loss completely dwarfs the often marginal annual tax benefits resulting from the ISA wrapper. 

Based on Office of National Statistics figures for holders of ISAs and PEPs, combined with our own research, WAY Group estimates that at least 165,000 elderly investors (aged 70 or older) are holding ‘tax-sheltered’ portfolios in excess of £100,000.  Based on published mortality rates this would mean that at least £0.5bn, or one sixth of the annual total IHT tax take of £3bn, arises from IHT on PEPs and ISAs from this group!  This cannot be right. 

I believe that there are substantially more then 300,000 investors across the country who currently hold substantial equities-based tax-free investments within their portfolios with no provision whatsoever for these funds to be transferred into alternative investment schemes which can mitigate the IHT. Over half of these investors – some 165,000 – of those with large tax-sheltered investments are aged 70 plus. This is the age group at the greatest risk of losing out on the tax-free benefits of their savings strategy. 

So what can these investors do to avoid IHT on their ‘tax free’ savings?  There are two parts to the answer, the first relating to accumulated savings already within PEPs and ISAs and the second dealing with future surplus annual income which might otherwise have been directed to ISAs. 

Accumulated PEP and ISA Savings
The obvious solution for redirecting accumulated savings is simple, even after Gordon Brown’s Budget measures from last year.  They should encash up to £285,000 of their ‘tax-free’ savings and gift them to their chosen beneficiaries via a flexible trust.  Although gifts into such trusts now constitute an IHT taxable transfer there will be no tax so long as the gift is within the current Nil Rate Band for IHT – £285,000 per person.  Such gifts fall out of account after 7 years and so there is an opportunity for each taxpayer to make gifts up to this level every 7 years. 

At age 65 the average investor still has a life expectation of some 16 years (males) to 19 years (females).  Even at age 75 these numbers are 9+ and 11+ years.  This means that any average investor has time to gift their former PEPs and ISAs completely IHT tax-free so long as they start shortly after their mid 60′s.  The real benefit of the tax exemptions associated with PEP/ISA portfolios is that when this IHT mitigation exercise becomes appropriate the targeted funds can be surrendered entirely tax-free at that point, making investment in an IHT mitigation plan that much more effective.

 There are a number of schemes available whereby trustees have a great deal of flexibility in making financial provision for both donors and beneficiaries. This means that investors can switch into IHT-protected investments knowing that their savings are beyond the tax man’s reach but not beyond their own reach, courtesy of their chosen trustees. Any investor with £250,000 in PEPs and ISAs is likely to save £100,000 of IHT by moving across to an IHT mitigation arrangement.  We are talking substantial potential savings here – the kind of savings which investors cannot ignore.  Not only does the client benefit but IFAs can earn worthwhile commissions or fees as compensation for the very complex work involved in establishing and monitoring the necessary trusts. 

Substitute for future ISA Savings
Many investors habitually save the maximum ISA allowance each year to obtain scraps of tax benefits which fall from the Chancellor’s table.  These sums simply compound the 40% wealth tax which Gordon Brown (or his successor) will collect on the taxpayer’s death.  So is there a more efficient use for these amounts of, generally, surplus income which will deprive Brown of his unjust desserts and yet benefit the investor? 

 Taxpayers have been using the ‘normal expenditure’ from income exemption introduced by Section 21 of the IHTA 1984 for many years.  This is normally exercised by straight unconditional gifts or by the establishment of simple trusts.  The fact that such gifts are immediately exempt from IHT is an exceptional benefit.  However donors making such gifts have hitherto been deprived of any future benefit.  Anybody unsure about putting funds beyond reach has therefore not taken advantage of this facility.  Since last summer WAY has offered it’s unique ‘Gifts from Income’ Inheritor Plan which allows donors to make instantly exempt gifts into a specially drawn trust but retain influence over those monies, including the right to have them reverted at some time in the future.

 What this means in simple terms is that investors who qualify for making ‘normal expenditure’ gifts can make regular savings not into ISAs, which will incur the 40% IHT charge on death, but into a Gifts from Income IHT arrangement, which offers instant IHT exemption (no waiting for the expiration of the 7 year inter vivos period).  Advisers only have to complete trust documentation with clients in the first year.  In subsequent years it is only necessary for funds to be paid across.

 The only caveat on this arrangement is that the regular gifts do genuinely qualify for the ‘normal expenditure’ exemption.  There are 3 rules for this: (i) the gifts (into trust) must be regular, (ii) they must be gifts from surplus net income and (iii) making the gifts must not adversely affect the donor’s standard of living.  So long as these conditions are met there is no limit to the size of regular gifts.  Some investors have substantial surplus income, sometimes tens or hundreds of thousands of pounds, which can be gifted in this way with immediate IHT exemption.

 So my message is clear – together we can help our clients and ourselves to obtain substantial financial benefits from switching from an ISA to an IHT mitigation approach where the only loser is the tax man.

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 2nd March, 2007 |
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Time for a pragmatic approach to risk profiling

Ever since the end of the ‘bear’ market in the Spring of 2003 I have been struck by the energy and intellect which has been directed at the issue of establishing each client’s attitude to risk.  Such paranoia has been evident after all previous major stockmarket corrections: after 1974, 1987 and now since 2003.

 Frankly nothing has changed in the last 100 years let alone the last 30 or so since we were all encouraged to bath together to save energy!  The message should be clear to us all: in the short term cash is king but in the long term equities unquestionably are king.  This truism is fundamental to the whole premise for free market economics.

This leads me to another fact which has been obvious to actuaries and scientists since economics was invented.  This is that volatility on any long term chart always looks as if it has been greater in recent times than in previous periods.  This is an optical illusion used by sceptical would-be investors to ‘prove’ that it is no longer worth investing in equities!  In fact the nature of an exponential curve (the natural profile of a long term equity index) is that apparent volatility only looks to be less the further back you go.  This is amply demonstrated by looking back at Black Monday and the 1987 ‘crash’ which it heralded.  This was a significant bear phase (as can be seen on the chart) which has subsequently faded into the context of what it really was . . a blip or straightforward market correction.  Suddenly, with markets touching previous highs, the recent ‘crash’ also begins to look like a natural and unexceptional market correction.

 The chart clearly shows the difference between market price and likely intrinsic value.  Whilst market price is largely determined by the balance (or imbalance) of willing buyers and sellers it is clear that it fluctuates around real value.  There is no way that the value of a company like Tesco fluctuates with its share price.  Its value generally moves rather more gently to reflect the long term trends of its fundamental balance sheet, profit and other financial ratios.  What the chart actually highlights is the importance of time rather than timing.  Whilst timing may be important in the specifics of buying and selling – far better to buy when prices are below value and to sell when they are above value – it is time, holding a high quality, actively managed portfolio for the longer term, which delivers sound sustainable returns.

 This, the fourth dimension of time, should be the starting point for discussions about risk.  I believe that one can establish a neutral and totally practical approach to risk from which one can then deviate for more cautious or more adventurous investors.  Developing a matrix from the premise of ‘short term cash is king, long term equities are king’ is straightforward and simply requires filling in the gaps between short and long term.  I consider short term to be up to 5 years whereas I believe long term means beyond, say, 12 years.  If 0-5 years means all cash and therefore nil equities and 12+ years means 100% equities then we can simply interpolate between these points.  I would say 5-8 years means 20-30% equities whilst 8-12 years means 50-60% equities.  Clearly it is also very important where the non-equity balance is invested but assuming this is also risk-graded in some sensible way we have a good working model for most average investors.

 Any investor investing for the future should attempt to predict the investment time horizon for different portions of his/her capital and then invest accordingly – in a different style of portfolio or fund for each time period.  The idea of determining each client’s ‘risk profile’ and then matching asset classes to this preference completely misses the point.

 As I see it the average investor would benefit from being in cash for any short term requirement and in a well-spread, actively-managed equity portfolio for long term requirements.  It is certainly not low risk for investors to be stuck in cash for the longer term.  Such an approach would be irresponsible – as the court has ruled in some well-known trust cases.

This brings me on to the contemporary approach of asking clients to complete long and tortuous risk questionnaires at the end of which, in true ‘Little Britain’ style, “computer says you are a cautious investor!”  Clients do not understand this process nor do they have sympathy with the conclusions.  If advisers follow this route to protect themselves, from a compliance perspective, I rather doubt its long term effectiveness.  Clients need to thoroughly understand how the conclusion about their risk tolerance was ascertained otherwise it might be considered false.  Frankly, a simple enquiry as to whether they believe they are cautious, neutral or adventurous investors would likely have been more effective. 

 I abhor such questionnaires.  Instead of subjecting clients to this torture I recommend a meaningful discussion about the nature of equity investment, its inherent volatility and the part played by time.  Such open and practical discussions should be properly documented.  The client should then be encouraged to analyse his/her future capital needs into time horizons.  These will then indicate a neutral position from which one can vary to reflect how adventurous, or otherwise, they are.

The era of the 1-10 risk categorisation of both clients and asset classes is long gone, thank goodness.  Matching a category 3 client with a long term Gilt approach never did make much sense.  In my view, however, we are going overboard with the academic approach and yet have still finished up categorising clients too broadly rather than looking at the main factor in risk – time.  So I give you my complete thoughts on basic risk profiling in the table.  Neutral means investing in the most obvious portfolio styles to reflect time horizons.  Only then should one consider the impact of the non-neutral client!

 

	5-8 years	8-12 years	12+ years
Low Risk Approach	Cautious	Cautious	Cautious
Low to Neutral Risk Approach	Cautious	Cautious	Balanced
Neutral Risk Approach    Typical equity content	Cautious 20-30%	Balanced 50-60%	Growth 90-100%
Neutral to High Risk Approach	Balanced	Growth	Growth
High Risk Approach	Growth	Growth	Growth

 

  

 

 

 

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 24th October, 2006 |
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