Secrets of Success: Taking the rough with the smooth

The annual spring envelope arrives with news of the fate of my near-forgotten endowment policy with Scottish Life, now part of the Royal London group. Royal London will soon become the largest mutual left standing in the life sector, following the impending flotation of Standard Life. The remarkable turnaround in policy at the mighty Edinburgh-based mutual shows that hand- bagging by regulators is a far more potent weapon than carpetbagging by policyholders.

Not for the first time, you can only marvel at the ingenuity with which the drafters of Scottish Life's corporate literature have managed to inject a positive note into this year's performance scorecard. On the face of it there is not much to boast about in the shape of a guaranteed reversionary bonus of just 0.5 per cent. This in my case equates to less than one month's monthly premium, and compares with an investment return from the fund that I calculate must have been around 6-7 per cent last year (the report surprisingly does not say, although it gives figures for the main segments in the fund, equities, property and fixed interest).

Brian Duffin, the chief executive of Scottish Life, is studiously non-committal about the future in his report ("another year of change and development"). Although its investment performance is not great, if the level of terminal bonus to be paid in six years is anything close to recent experience, it looks plausible that the fund could still more than pay off its target sum when it matures. By then it will be more than 10 years after the stock market peak of December 1999.

What will the pattern of returns and bonuses look like in 2010? It will depend in part on future investment returns, and also on whether or not the fund is still around and alive, rather than closed by that date. (Whatever the broader merits of the argument about with-profits policies, it is an unavoidable fact that the worse the publicity they get, and the more that sales of new policies decline, the worse the outlook becomes for policyholders in both surviving and closed funds).

However, given a fair wind, and some measure of investment freedom, it seems a fair bet that in six years' time smoothing may again be working in favour of, rather than against, those whose policies are reaching maturity. The industry is right to point out that 25-year returns on endowments have always been positive, but the evidence from actual payouts suggests that smoothing does not work as well in practice as it should do in theory.

If you look back at the history of long-term payout ratios, using the data series provided by Money Management magazine, you find that there are years when even 25-year-old policies pay out a sum that represents nearly twice the real compound annual rate of return delivered by the same fund in other years - not much equality of outcome there, even allowing for the exceptional returns of the 1982-2000 period.

As to why this alarming disparity should exist, there may be a clue in the current asset allocation of the fund, which is 60 per cent in fixed interest, 18 per cent in equities, 12 per cent in property and 10 per cent in cash and "other" instruments. The latter includes some derivatives that are being used "to reduce the risk to the fund of future interest rate reductions which would otherwise have an impact on the fund's ability to meet guaranteed liabilities".

What this seems to mean is that the fund is being forced to take out some extra insurance against the prospect of its balance sheet not passing regulatory tests in future. Whether the asset allocation of the fund is the one that the company would have pursued had it not been for the demands of regulators is not known. History suggests that for a host of reasons large investment institutions are typically caught on the wrong side of big market moves, being overweight in shares at the top of bull markets and underweight at the bottom, so being wrongly positioned a year ago would hardly come as a total surprise.

In the case of my Scottish Life fund the biggest move it made last year, other than buying protection through derivatives, was to move further out of equities, which performed well, and maintain their 60 per cent weighting in fixed interest bonds, which did pretty poorly and continue to look full of risk at current yields. Even for a fund which is rightly not managed for short-term returns, this does not look so smart, even if many other life funds went in the same direction. There seems no doubt that regulators played more than a small part in that decision.

From a policyholder's perspective, the combination of regulatory intervention in asset allocation and the companies' own shortcomings does not inspire great confidence. For a whole variety of reasons, this kind of experience helps to make a DIY solution for those who can afford to manage their own risk look ever more attractive. On the other hand, if a life fund can deliver a real return of, say, 3-4 per cent over its term, which could well still happen, you could argue that it has done its job.

The problem with endowment mortgages in general, of course, has been that it was crazy to try and sell policies that promised real absolute returns with a high degree of reliability to people who bought them to meet a future liability - a mortgage repayment - that is fixed in nominal (cash) terms at the outset.

Working my way through the latest fund performance statistics, it is interesting to look at the names that top the five-year performance tables, both before and after adjusting for risk. The first camp, as always after years when risky assets have done well, is dominated by specialist funds that happened to be in the right sector at the right time. The second camp is more interesting, however, as it includes a number of funds run by experienced managers whose investment style is dominated by one simple fact: their portfolios look very different from that of the market as a whole.

As Anthony Bolton, the doyen of Fidelity's fund managers, pointed out many years ago, the one certainty in stock market investment is that you cannot hope to beat the market by much unless you do something very different to what the market is doing.

This is not exactly brain surgery, but it is a fact of life that majority of funds in this country are not run that way, although they still charge you an active management fee for not making the effort.

jd@intelligent-investor.co.uk