Alex Montgomery: Recovery can't hide the challenging times ahead for investors

THIS is a fascinating time to be involved in financial markets. Although it now seems like another era, it was only a few years ago that US Federal Reserve chairman Ben Bernanke and others were describing the prevailing conditions of consistent global growth as "the great moderation".

This period of expansion without great volatility began to unwind with the emergence of a credit crunch in 2007, snowballing over the following year into the greatest economic crisis and financial market panic since the 1920s.

The concerted action taken by central bankers and governments in the world's leading economies has brought us back from the brink. However, their actions have, in effect, moved western consumers from a serious debt dependency habit into a "rehab" of super-low interest rates and abundant liquidity. Life in rehab has been sweetened by stimulants such as the "cash for clunkers" schemes that have supported the ailing car industry.

One consequence of the rehab environment has been a change in investors' behaviour. As central bankers opened the taps, so the flood of liquidity and unattractiveness of bank deposit rates have at least partially restored investors' appetite for risk. While investors remain bruised, they have driven the prices of many financial assets higher over the past nine months. While we remain in rehab, we are expected to feel protected from the consequences of having accumulated large debts in order to fund consumption rather than savings. But sooner or later these problems will have to be faced. If borrowing, expenditure and saving habits are to be brought back into balance, consumer spending will fall.

Our temporary rehab clinic is being run at enormous cost; one that we are not paying for. That will come in time when the next and subsequent governments will be forced to raise taxes or lower expenditure in order to reduce the currently ballooning national debt.

So, how should investors approach their portfolios? The traditional approach to investment for private investors is no longer appropriate. When looked at overall, the past decade has been an extraordinarily unrewarding time for risk-taking investors. Also, throughout this period there have been significant developments in the financial markets that have brought fresh asset classes on to the investable radar screen of private investors.

Traditionally, private investors' portfolios tended to be built from a combination of: shares in UK companies; pooled funds providing exposure to overseas stock markets; gilts to provide low-risk fixed-interest exposure; and perhaps some modest exposure to commercial property, commodities or other diversifying asset classes.

But what more can be done now? Tax should be the first consideration. If an investor's capital gains are taxed at a maximum rate of 18 per cent when income is taxed at 40 per cent or perhaps even 50 per cent, it makes little sense to focus on income generation if a different approach to asset allocation, with a much higher proportion of the return being received in the form of capital growth, can deliver a similar overall return. There are certain tax structures that can be used to hold particular types of investment to dramatically enhance the tax efficiency of investment returns.

Secondly, it is very hard to see value in conventional UK gilts at their current price and yield levels. Selective use of corporate bonds and bond funds can provide a material uplift in returns without a significant additional risk, although it is worth noting that the opportunities in this area are not nearly as attractive as they were a year ago.

Perhaps the biggest change over the past ten years has been the dramatic improvement in the range of opportunities in "alternative" asset classes, such as hedge funds, structured products and infrastructure investment vehicles. However, these are all extremely complex areas where there have been instances of very poor performance, unexpected losses and extremely high, and sometimes hidden, charges. Considerable expertise is required to identify the most attractive opportunities.

We can be relieved the heart attack suffered by the global financial system in late 2008 did not lead to a longer and more damaging spell in intensive care. However, it would be wrong to assume the patient has made a full recovery – this will continue to be a very challenging time for investment.

• Alex Montgomery is a partner and head of asset management at Turcan Connell.