Trustees’ objectives are defined by the trust instrument but there is always a duty of care towards the trusts and the beneficial interests. The standard of that care is weighed against the particular purpose and circumstances that are applicable. However there is a strong inference that the law of Equity would require the trustee to preserve the value of capital above all else (as opposed to enhancing returns). This raises the question as to how to measure such capital. Ought it to be in nominal or real terms, for example. It again depends on the trusts and the particular circumstances in which they are acting.
However, what follows is an outline of an approach that the trustee might follow when exercising his investment powers that aims primarily to preserve the real value of capital.
The aim of this investment strategy is:
To deliver absolute real returns against a declared and reducing time horizon;
To behave possessing low volatility and standard deviation;
To perform against a reference currency of either sterling, euros or a basket based reference;and
To be made up of easily marketable securities under ordinary conditions.
This investment strategy centres on index linked government bonds, hereafter called GL for short. Conventional government bonds shall be hereafter referred to as GC. An allowance and allocation of 30% will be permissible in gold companies, utilities, foreign currencies, high yielding blue chips and ETF’s that are germane thereto.
The theoretical basis for this strategy is the proposition that:
All investment is deferred spending therefore of primary importance is the maintenance of purchasing power or real capital value;
That equities have produced the highest passive returns over time horizons of more than twenty years;
That investing in equities ought to be restricted to times when they represent good value versus historical parameters otherwise deep potentially irrevocable losses are a real possibility.
In sum therefore this is an investment strategy giving priority to real returns centred upon GL securities and offers simplicity and high levels of assurance as to outcome. Valuations are still important but so too can be opportunity loss. If there is a ‘bird in the hand’ situation the GL class may offer the best compromise subject to the risk of deflation or unfavourable trends in interest rates. Going on, return may be supplemented from calculated exposure, up to a 30% allocation, to other asset classes.
Inflation ‘the Key’:
Underpinning this strategy is the importance attached to removing some degree of inflation risk out of a portfolio, subject to market conditions. This could be because it is thought that the market is complacent about its cost or when it represents a competitive option because money market interest rates are negative in real terms.
The causes of inflation (pace Dr John HUSSMAN) are regarded to be as follows:
In Partial Equilibrium:
The theory of economic marginal utility observes that the more one has the lower the enjoyment through use. This utility declines and then even turns negative say after the fifth Mars bar! There is equilibrium between money, goods and services across an econony at any time. This equilibrium is dynamic and always adjusting to new circumstances. For example, if money attracts a high level of interest one may prefer to save and not spend and visa versa.
“The dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar. So how do you get inflation? Simple.
Increase the marginal utility of ‘stuff’. This happens either if the supply of goods and services becomes more scarce, or if the demand for goods and services becomes more eager.
Reduce the marginal utility of dollars: This happens either if the supply of dollars becomes more abundant, or if the demand to hold dollars becomes weaker.”
On top of this micro-economic analysis (or partial equilibrium) it is necessary to consider also general equilibrium that takes account of an economic constraint caused by government spending. This is attributed as the driver of longer term inflation.
“…regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper – a government liability – in return that has to be held by somebody. ….. To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities. The marginal utility of government liabilities of all types tends to fall, and you get inflation.
Contrast this with the Great Depression. Output declined enormously, but goods and services weren’t scarce because of production constraints. Rather, output fell because of a major reduction in demand. So the marginal utility of goods and services most likely declined during that period even though production itself was down. In contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert deposits into currency, so even the monetary growth that occurred wasn’t nearly enough ….. translated into a major increase in the marginal utility of money.”
Quote of J D Hussman of Hussman Funds- A primer on inflation
Summary:
Democratic nations of this age and other political arrangments of the past have all been inclined one way or another to tax and spend actively. Given that a period of growth in government spending might, if unproductive in economic terms, lead to a follow on and similar period of length of inflation one can observe and predict this phenomenon.
At the same time there is a governmental approach that tends to encourage some inflation in order to keep deflation at bay. At times of financial restructuring (of the levels of debt in an economy) this inflation assists borrowers and punishes savers in real terms. Encouragement of this kind may take the form of lowering deposit rates to very low levels or programmes of quantitative easing the former of which may increase monetary velocity and the latter of which may produce a budgetary constraint which risks being inflationary after the event.
The GL class of securities offers a means for trustees of hedging against and profiting from the inflation complex.
Note:
Fisher equation:
(1+n)=(1+r)(1+f)(1+p) derives n=r+bei