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.
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”.
The risk models used in risk-based, asset-allocation tools are generally backward looking, taking into account historical volatility of an asset class when assigning the optimum portfolio weighting in, for instance, cautious portfolios.
But the problem with this method is that assets can have ultra-low historic volatility all the way up until they crash. For example, property funds and assets had very low volatility in 2007, right up until the financial crisis that saw devastating losses across the sector.
Ultimately, Mr Webster claims he does not know what the right solution is to problems with asset allocation, so cautious funds remain in difficult straits.
He says if he had a 10-year time horizon, he would rather put all his money in US and UK equities than gilts, from a risk-versus-reward standpoint, but that isn’t something a cautious client would be comfortable with.
But until a solution is found, many cautious investors are saddled with significant weightings in gilts and other assets on historically high valuations.
Some managers, notably Schroders’ Marcus Brookes, have completely rejected gilts in their cautious-managed funds. But the only asset class left to move into is cash, and Mr Brookes’s 30 per cent cash weighting proved a significant drag on his Schroder Multi-Manager Diversity fund in 2014, causing the product to deliver bottom-quartile performance.
In the absence of any value from gilts and gilt-related assets – and with the risk-reward balance firmly stacked in favour of the risk with very little potential reward – investors may well be better off with large cash weightings for the time being.
Mr Gallacher has been doing this for cautious clients – moving them out of fixed income and into higher-risk assets, but attempting to balance that out through higher cash weightings.
But the concern for the industry is that these issues with cautious portfolios seem to be building just in time for the pension freedom reforms, which are expected to lead to high demand for multi-asset products, of which cautious funds are likely to take up a significant proportion.
It is potentially a clear and present danger to a whole generation of savers and one that may need a concerted and co-ordinated response from the industry to solve.
Matthew Jeynes is deputy news editor at Investment Adviser
