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Are cautious funds too risky?

Are cautious funds too risky?

Growing concerns from financial advisers about the level of gilt exposure in cautious-managed funds were uncovered in last week’s Investment Adviser.

But the problem is so much more than just being about gilts.

It has become a common refrain from advisers to hear them saying that managing a cautious portfolio, especially for an elderly client, is one of the hardest jobs they are faced with at present.

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Scott Gallacher, director of advisory firm Rowley Turton, says: “The hardest job at the moment is dealing with older, cautious clients.”

The difficulty comes from the paucity of low-risk, uncorrelated assets and the fact most of these few options have been pounced on by large numbers of investors and are now expensive.

Infrastructure investment trusts, seen as an uncorrelated asset with a decent yield, have seen their shares trading on huge premiums to the net value of their assets for years now, with some even rising higher than a 20 per cent premium. This means paying £1.20 for every £1 of the value of the assets in the trust.

And the story is similar in other supposedly low-risk assets, where investors are buying in with the hopes of safety but in reality are being exposed to assets on record-high valuations.

Psigma chief investment officer Tom Becket has become so concerned about the issue that he has embarked on putting together a white paper researching cautious-managed funds and what can be done to mitigate the problems they face.

Mr Becket thinks cautious funds have “never been more risky”, with issues across all assets generally held within them.

“Cautious portfolios have now never been more risky because they are all linked to the same trade, which is low and falling government bond yields,” he says.

“Investment-grade bonds are very dangerous because they are tied to gilts, but so is everything else – real estate investment trusts, infrastructure and dividend-paying equities. Everything is tied to lower government bond yields.”

While he didn’t want to commit to any specifics on what the solutions should be to the cautious-managed problem, Mr Becket says the most investors can really do for now is to introduce as much diversification as possible into their portfolios, to mitigate against the risk of one or more of the assets suffering a tumble in value.

Simon Webster, managing director of chartered financial planning firm Facts and Figures, notes the problem for cautious funds means he is “starting to think we really need to revisit current risk-based asset allocation models”.

He says such a radical action has been on his firm’s agenda, but he is holding off because it will require a “massive rejig” and fly in the face of what seems to be the general direction of travel for the industry.

“The FCA’s view would also have to be considered,” he adds.

Mr Webster recalls the impact of the regulator’s tighter solvency requirements, introduced in 2003, that led to insurers such as Standard Life slashing the equity holdings in their with-profits schemes in order to move into gilts. This was “just before a massive equity rally”, he says, so it may have “cost with-profits plan holders a fortune”.