Secrets of Success: Beware funds that hold back dividends

Scanning the usual crop of new year predictions once again reminds us of the force of JK Galbraith's axiom that economists make forecasts not because they know, but because they are asked.

Scanning the usual crop of new year predictions once again reminds us of the force of JK Galbraith's axiom that economists make forecasts not because they know, but because they are asked. In the case of brokers and other professionals with a vested interest in higher share prices, the safest bet continues to be to predict that the market will rise by around 10 per cent each year - which is where most such forecasts seem to have clustered.

This figure is no accident. Given inflation of 2-3 per cent per annum, it equates to the long-run return from equities as an asset class (7 per cent in real terms). It is notable that the most successful fund managers are more cautious about the outlook. My sense from talking to them is that most will be happy if they can register positive gains for the third year in a row.

The odd thing about 2004 is that it did in fact turn out to be that rare thing - a fairly average year. Bonds did little in price terms, despite some serious wobbles on the way to a mid-single-figure total return. The stock market (as measured by the total return of the FTSE All-Share index) hauled itself up to a return of just over 10 per cent, continuing the recovery from the market lows of spring 2003.

The other striking thing about the past year is that volatility fell to very low levels. Notable exceptions to this were a rising oil price, the continued outperformance of midcap and some smaller company shares, the final apotheosis of the house-price bubble and a fall in the value of the US dollar. Emerging markets and commodities also did well.

Looking forward, as always, it is easier to predict which variables are likely to change at some point in the future than to make specific forecasts about when that will happen. A good approach is to log trends that have moved out of kilter with their recent or long-term course and adjust your exposure when each looks like reverting to its traditional relationship.

In general, it can be said that the period of relative outperformance by smaller companies will end soon in favour of the large-cap sector/FTSE 100 index. The point when technology shares start a sustainable upward trend is also approaching - though my hunch is that it may be 2006 before it gathers pace.

In terms of overall market performance, next year, the first year of a new presidential term, is likely to deliver poor returns. It is traditionally the point at which tough measures to stabilise the economy after two years of blatant electioneering are introduced. This may already be happening to some extent, judging by comments from the Federal Reserve that imply a more aggressive tightening of monetary policy this year than some expected.

If you look more carefully at what happens to the US stock market, however, history suggests that when first years of new terms are good, they are very good indeed, typically with gains of more than 20 per cent. So if volatility returns, 2005 will almost certainly be an exciting year one way or another - the exact opposite of the consensus forecast. In the short term, however, both the US and UK stock markets look over-bought, as the chart suggests, with director selling in particular at a very high level.

One other prediction I make with some confidence is that 2005 will again be a good year for those selling "structured products". These are instruments that use derivatives to offer investors a tempting array of new risk-reward combinations. I confidently predict that some of these products will again cause regulators, investors and financial advisers difficulties in the months ahead. If you are tempted by one of these new products, approach with care - they can be difficult to analyse and model.

Take, for example, a new product, sponsored by the Woolwich Building Society, that offers investors the chance to invest in the stockmarket with 100 per cent capital protection and the chance to choose, at the end of the five-year term, which of three leading market indices they wish to have the bulk of their money invested in. This is the first time, in my experience, that hindsight has been used as an investment marketing tool.

The product in question is a form of investment bond that you have to hold for five years. At the end of the period you get your initial investment back, plus a capital return linked to the level of three market indices, the FTSE 100-index, the S&P 500 index and the Dow Jones Eurostoxx 50 index. Investors have the option to put half their money into the one that has risen most, 30 per cent into the second-best performing index and 20 per cent into the third-best index. There are penalties if you cash in before the five-year term, but charges are taken account of in the promised return formula.

Sounds good? Maybe. The two catches are that the market return is based on the average index level in the fifth year, not the end-year level (which will cost you something if the market finishes the period rising), and - more seriously - that the return is limited to capital growth in the indices, without any credit for dividends. At current-dividend levels, that will cost you some 15 per cent of the market's overall return over five years, and the charges (though included) will take up to an extra 7 per cent. So you are giving up more than 20 per cent of certain return, plus the use of your money for five years, for a no-risk punt on the more unpredictable capital level of three stock market indices.

It is hard to say whether this will turn out to be a good or a bad bargain (such fixed-term products are always a bit of a punt). Dividend-free stock market investment is not in general a good choice, as reinvested dividends account for the majority of stock market returns over time. But the new product is certainly ingenious, and evidence that marketing will continue to pull in the pounds this year by making investment seem a much simpler business than in truth it really is.

jd@intelligent-investor.co.uk