It is something I’ve been talking about with clients and portfolio managers, advocating increased exposure to alternative asset classes that are less correlated with equities and bonds, such as proven absolute return funds and physical gold, as well as looking to reduce overall downside risk.
While reducing risk generally means having less in equity, in most cases it is not appropriate to have no equity exposure at all. The toolbox of both active and, increasingly, passive funds contains a range of styles, and investors have many options to take a more defensive stance, rather than just accepting full, broad market risk. Part of this can be achieved simply by looking for fund managers or strategies that tend to avoid some of the more cyclical sectors, such as mining, house building and banking. But it doesn’t mean just buying ‘expensive defensive’ stocks either.
A good approach is to find managers who invest in companies that have steady earnings and cashflows, stable business models and a healthy balance sheet that isn’t loaded full of debt – what some might call ‘quality’ stocks, though a sense of valuation is also important, so you’re not over-paying for these defensive qualities. You can also look for mandates that give the manager flexibility to hold cash, when they feel it is appropriate.
In the portfolios we run, we’ve been increasingly favouring these more cautious fund managers and, while they might be expected to get a little bit left behind during sharp short-term rallies, they are more likely to protect on the downside during market routs, enabling them to rise from a higher base afterwards.
Although, of course, past performance is no guarantee of future returns, it can be instructive to see how these funds have performed historically during different scenarios, such as the equity market falls in 2007-09. By way of example, within our preferred list of UK Equity funds, both JO Hambro UK Opportunities, managed by John Wood, and Liontrust Special Situations, managed by Anthony Cross and Julian Fosh, fit the bill. During the global financial crisis, while the maximum drawdown for the FTSE All-Share was 41.1 per cent, the JO Hambro fund only slipped 27.8 per cent, and the Liontrust fund shed 34.5 per cent.
Similarly, advanced beta funds, such as the iShares MSCI Europe Quality Factor Ucits ETF, aim to mechanically identify quality stocks. Although the ETF is unproven through a market cycle in a live format, the back-tested numbers are encouraging, and this is an example of how passive investors are no longer constrained by the limitations of broad market investing.
When it comes to expressing investment views in client portfolios, using the right fund can be almost as important as getting the asset allocation right. This is not always easy. It requires thorough assessment of funds’ process and philosophy, portfolio holdings and performance analysis, to gain an understanding of how a fund is likely to respond to different market conditions. But this is clearly an important area to get right.
Ben Seager-Scott is director of investment strategy at Tilney Bestinvest
