Many investors have grown accustomed to the bull run, but the past few weeks have been a crude reminder of what can happen if the markets take a turn for the worse. How do multi-managers adjust their portfolios for a bear market? asks Christopher Salih
The recent stock market upheaval has left a lot of advisers wishing there was another solution. Who wouldn't rather be without phonecalls from anxious clients worrying about their equity portfolios? Yet, equities can seem a necessary evil. You have to invest. Cash is boring, bonds are over-valued. The multi-manager that can find funds to produce returns in a bear market is a valuable commodity indeed.
The investment compass has swung away from benchmark-focused investing. Managers have become accustomed to running vehicles with a more aggressive approach. And the past three years have been kind, with even poor managers generating decent returns. But declining markets provide the biggest test. Many managers claim to be absolute return focused and protect capital in a bear market. But which managers actually protect client investments on the downside, while participating in some of the upside?
Evaluating whether a market decline represents just a blip or a long-term problem is a key skill for multi-managers. Miton handled the last bear market particularly well. Tom McGrath, fund manager at Miton, says: "For us it is all about asset allocation. We used cash, gold and fixed interest as three strong pillars of defence against the bear market. When I joined Miton in 2001, Martin Gray was already holding over 10% in cash, which meant we had to write a letter to trustees every month to justify our position and in hindsight we are pretty glad we did."
Gary Potter, co-head of Credit Suisse multi-manager services, says: "If you take our Constellation fund, the effect of the bull or bear market has not really affected its performance. Up to March 2003 (arguably the end of the bear market) the fund performed 13% above the global equity sector. In today's bull market the latest stats show it being 16% above average."
Potter says the key is to balance the range of funds available. He adds: "Although we will always stay the same on our equity positions, we will look at the environment and decide whether it is best to have more defensive players or attackers. It's horses for courses, you have got to look at whether you're playing Barcelona away or Dover at home, and then make sure you have the right tools to do the job."
So which funds were the success stories in the last bear market? Miton used the Gartmore US bear, a fund which generates returns opposite to the S&P 500 Index. Between May 2001-2002 the fund produced an 11.9% return compared to a sector average of -1.5%. Other funds the group employed over the period included Merrill Lynch Gold and General, Barings Euro bond fund and the M&G Gilt fund.
Mark Dampier, head of research at Hargreaves Lansdown, says: "While some will always go into cash to defend their position others prefer to stay in equities. Lee Guardhouse, for example, will always pick the best equity managers because in spite of any situation they will always see you through."
Potter says Credit Suisse took up a higher percentage in more defensive positions in the last bear market. He comments: "We used funds that knew how to defend themselves in these markets, the likes of Odey Continental European Trust and Gartmore US Opportunities served us well at the time and still do now."
Jason Britton, fund manager at T. Bailey says: "The funds that served us well in the bear market tended to be our longer-term holdings. Artemis European Growth is a good example; it operates on its own neutral, robust process. Scottish Life recently launched another robust process in the shape of its own fund matrix."
Britton says all multi-managers have to cater for clients over the long-term. They have to be able to manage money well in any conditions. He says: "Investors are typically looking to invest for a minimum of five years, which is arguably a market cycle in itself. Investment in fund of funds should be an even longer tenure because of the buying and selling of funds and manager changeovers, say between seven and 10 years. That means you have to be versatile enough to manage in any market conditions."
How many groups can continue to perform if the market turns from its current bull run, as it has threatened over the past few weeks? McGrath believes that responding to a bear market will be much tougher on this occasion. He says: "The opportunities we exploited last time aren't as readily available on this occasion. When we bought the Legal and General Gold Fund it was one of the only gold funds around. Gold is now at an all time high and consequently the opportunities available are now at a considerable premium. Fixed interest has also been hit in recent times making it a less popular investment alternative now. Providers may have to look into cash and structured products, things that have no correlation to equity."
A helping hand
Potter believes all good managers should be able to find opportunities. He says: "It doesn't matter whether it is a bull or bear market, a manager should always be able to adapt and know that there are always good opportunities. It is a case of adjusting the squad to suit the environment."
The wider investment powers adopted by Ucits III, giving groups more freedom over the types of investments they have is another positive for managers in the future. McGrath adds: "There is enough flexibility in Ucits III to help providers in the bear market. It allows groups to make use of Nurs (Non-Ucits Retail Schemes) as well as letting you invest in commercial property and direct hedge funds. There is more than enough to work with there."
A spin-off from Ucits III, Nurs can make limited use of derivatives, but most fund managers use them for risk management, rather than profit. It allows managers the freedom of going 100% cash to protect from losses.
Dampier says: "Some diversification may help, but by the same token things like commercial property are overpriced. If markets do not look that hot it is best to go into cash. Do not forget fixed interest can also get hit. Of course clients want to make money, but if you defend their investment in a bear market they can't complain."
He adds: "Experience is absolutely essential. A lot happens in a bear market and managers have to make big decisions. Some have to look at how much cash they want to use to protect their investment, while realising that when the market turns they have to buy back funds in that important 10-to-15-day window."
In hindsight, Potter thinks there are a couple of things the CSAM multi-manager team could have done differently in the last bear market. He says: "Across our range we would definitely liked to have held one or two more fixed interest funds as insurance, as well as holding a bit more cash than we did. Like most multi-managers, we love diversification. It stands well over different markets, whether some do better than others."
McGrath adds: "Bear markets can often teach fund managers a lot, especially the more pessimistic side of the business. Lots of new fund of funds boys have only experienced the upward side of the market, and have yet to learn just how volatile investments in Eastern Europe and Japan can be on the downside."
With three years of strong returns and an abundance of new funds and talent joining the multi-manager market, it is hard for many to cast their minds back to the dark days of 2002 when markets were going south at a rapid rate. The past few weeks have been a crude reminder. While many will claim vehemently that they can defend a client's investment in the bear market, as well as participating in any bull run, it takes a truly skilled manager to preserve capital in all market conditions.
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