The Swallow Financial approach to long term investment management

1. An Detailed Explanation of How To Invest For The Long Term

3. Preamble Throughout these notes we have tried wherever possible to use 20 years of data, starting in July 1990 and finishing in July 2010. Some of the July 2010 figures are estimates (as the finalised data is not yet available). In July 1990: • Inflation was standing at 9.34% • Bank base rate was at 15.00% • The FTSE 100 was at 2,326 In July 2010: • Inflation is at 4.78% • Bank base rate is at 0.5% • The FTSE 100 is at 5,258. Back in 1990 if you used 10 year GILTS to generate £10,000 of income you would need (ignoring costs) £84,459. To achieve the same income using 10 year GILT yields in July 2010 you would need £336,700, which is an annualised rate of return of 7.16% over the 20 year period. Had the FTSE 100 grown by the same sum it would now be at around 9,273. (Bank of England, FTSE and Wren Research statistics).

4. Why Invest in Assets Rather Than Cash? Over the longer term assets tend to perform better than cash or inflation:

5. Are Some Asset Classes More Volatile (Risky) Than Others? So Emerging Markets has an average return above 10% but in any one year this varies between -22.5% and + 32.5%. Cash averages at 6% but in any one year this varies between 3% and 9%.

6. What About a Combination of Asset Classes? Empirical evidence has shown that if you combine asset classes the end result is greater than that of the composite parts. By choosing uncorrelated assets you can achieve reasonable returns in most markets as when some assets are going down, others normally rise. A correlation of 1.0 indicates a perfect association, a correlation of 0 indicates no relation & a correlation of -1.0 is a perfect disassociation 07/1990 to 06/2010 1.00 (0.17) (0.17) (0.04) (0.19) (0.02) 0.13 Global Bonds - 1.00 0.71 0.63 0.61 0.67 0.41 Emerging Markets - - 1.00 0.60 0.46 0.35 0.32 Property - - - 1.00 0.76 0.70 0.72 International - - - - 1.00 0.86 0.79 UK Small - - - - - 1.00 0.84 UK Value - - - - - - 1.00 FTSE 100 Global Bonds Property Emerging Markets International UK Small UK Value FTSE 100 Data Series

7. Different Asset Classes For Different Risks At Swallow Financial Planning we categorise clients into one of 7 risk categories. These are based on your FinaMetrica score (1 to 100). If you want to know how we do this, please refer to our Risk Profile notes. So the most cautious investor (i.e. with a FinaMetrica score of less than 20) is the wary one. On the other hand, the high risk investor (with a score of 90 +) is “Gung Ho”. holding the most volatile assets. Investment option Investor Type FIXED/ CASH PROPERTY EQUITIES TOTAL UK Intl UK Intl UK International Core Value Small Main Markets Emerging Markets 1 Wary 90.00% 10.00% - 100.00% 2 Cautious 60.00% 15.00% 10.00% 5.00% 10.00% - 100.00% 3 Prudent 30.00% 20.00% 15.00% 5.00% 15.00% 5.00% 10.00% 100.00% 4 Balanced 15.00% 10.00% 15.00% 10.00% 15.00% 5.00% 5.00% 20.00% 5.00% 100.00% 5 Adventurous 5.00% 5.00% 15.00% 5.00% 20.00% 10.00% 5.00% 27.50% 7.50% 100.00% 6 Speculative - - 10.00% 5.00% 23.00% 10.00% 10.00% 27.00% 15.00% 100.00% 7 High Risk - 10.00% 20.00% 20.00% 30.00% 20.00% 100.00%

8. Combining Assets Creates Better Returns The High Risk portfolio contains the other asset classes but has beaten all but emerging markets whilst generating far less volatile returns (total return over 20 yrs 452%)

9. Combining Assets Creates Better Returns Again the Prudent portfolio contains the other asset classes but has beaten all but Bonds and UK Value whilst generating far less volatile returns. (total return over 20 yrs 370%)

10. Different Asset Classes Reduce Risk Risk, in investment terms, is usually different from what a lay person considers as risk. Most lay people consider a risk as the risk of losing the physical value of their money. In investment terms is not the physical risk to the initial capital value, but rather it is the risk the investment will perform better or worse than expected. This is also called the standard deviation to the norm. If we look at the returns for the above asset classes over 20 years we have a table as follows: As you can see, the use of a mixture of assets overall generates better returns at lower risk than does an equivalent asset class.

11. Wary has an average return of 6% with a best return of 14% and a worst return of 1% whereas Speculative has an average return of 9.7% however its best return was 40% and it’s worst return in a year was -19% If you don’t like the risk, choose a lower long term return. Better returns mean higher volatility

12. The Longer The Term The More Certain The Return If you look at the best and worst returns from a selection of our recommended portfolios you see the following: If you don’t need your money for 10+ years you can affird to take more risk knowing the return is more likely to be as expected. Annual: 07/1990 - 06/2010; Default Currency: GBP Best / Worst Returns 0% 10% 20% 30% 40% -10% A n n u a l i z e d R e t u r n 1 Year 3 Years 5 Years 10 Years 15 Years 20 Years Rolling Time Period High Risk Balanced Prudent Wary

13. This graph shows the average returns over 10 years ending in June each year. As you can see the returns from all investments have been falling meaning we have to be far more aware of investment costs. Long Term Returns Have Been Falling

14. Passive Funds Will Generate Better Returns We explain our approach to investments in “Our Approach to Investment Management” notes. In brief, we believe investment returns in future will (on average) be relatively low. If an average passive fund has charges of 1% and an average managed fund has charges of 2.5% then managed funds cannot consistently match passive fund performance £10,000 at a gross annual return of 5% over 20 years will grow to £26,500 with no charges, £21,911 in a passive fund or £16,386 in an active fund meaning the active fund has to grow by 30% better than the index just to keep pace with it.

15. (Source: Lipper Hindsight growth total return, default tax rate, in £ to 31/12/2007) This schedule indicates the percentages of funds over 5 years which generate above average performances. With less than 5% of managed funds achieving a consistent return better than average, why take the risk? Managed Funds Do Not Beat The Index Sector Total Number of Funds Funds producing above average returns for: 31st December 2007 3 consecutive years 5 consecutive years Funds % Funds % UK All Companies 346 38 10.98% 13 3.76% UK Corporate Bond 121 15 12.40% 5 4.13% North America 90 10 11.11% 1 1.11% Europe (x UK ) 110 14 12.73% 3 2.73% Pacific (x Japan ) 75 13 17.33% 2 2.67% Japan 63 3 4.76% 0 -

16. Do Not Time The Market! The Graham and Campbell study of 237 market timing newsletters showed that less than 25% of the “experts” predicted the right outcome once, let alone consistently. If we cannot get the asset timing right, we believe clients should remain invested in their optimum asset classes. Emerging Markets International Equities UK Small UK Value FTSE 100 Property Bonds Cash

17. Summary Within this presentation we have tried to show in graphical form why we believe clients should have a diverse range of investments set up according to how much they are prepared to see the capital value of their investments fluctuate in the short term. We have also tried to explain why you should choose different sectors of the market which may well perform better than others over the longer term. Finally we have touched on our reasons for using passive rather than active fund managers. So looking forward, what might the circumstances we find ourselves in now suggest that the next 20 years might bring? Well firstly fixed interest rate investments can only go one way. If the underlying interest rates now are effectively 0%, then the yield over the next 20 years can only go up (as most institutions and individuals will not want to pay people to hold your money it seems unlikely that interest rates will go significantly into the negative!). If yields go up, the capital value of fixed interest securities (i.e. Government gilts and corporate bonds) will fall. One could also argue that the long term outlook for commercial property is also somewhat subdued. If interest rates do rise then there will be some narrowing of the very wide risk margins we see now (typically yield to value are in the region 8% to 10% at present) but eventually the capital values will fall. Against this, however, there is the influence of new build costs to consider so there is always an element of inflation proofing over the longer term. The value of an equity is the value of its dividends over the life of the share, so if the outlook for certain markets is uncertain (i.e. the gradual lowering of western standards of living in comparison with those in developing countries) then one needs to be circumspect over where one invests on a macro level at least. But no one know what is going to happen! One thing we can be certain of is that if you want your investments to keep up with and hopefully beat inflation you will have to accept risk. This presentation explains how we try to give our clients the best returns for the minimum of risk in the years ahead. Andrew Swallow August 2010 .