Clients seeking to avoid risk need to look beyond the label 'cautious'. Split caps, precipice bonds and with-profits funds have all been tagged as 'safe' in recent years and all have lost investors significant amounts of money. Cherry Reynard investigates just what makes a cautious investment
Some of the riskiest investments of recent years have been tagged 'cautious'. From split caps to precipice bonds, income-generating products have repeatedly been mistaken for safe investments. With-profits - also badged as safe investments - have too often seen poor returns and high charges.
It is often those products demonstrating significant volatility, such as some of the top-performing UK equity funds, that have genuinely protected investors against downturns in the market. So what should investors be looking for when selecting a cautious investment?
Initially, it is worth disabusing some of the myths around cautious investing. Firstly, that it is all about volatility. Low volatility equals low risk while high volatility equals high risk. Alastair Mundy, manager of the Investec Cautious Managed fund, says: "We don't use volatility as a measure of risk. We have been looking at a company that has had very high volatility over the past five years. It has gone from trading at 3x the value of its assets to 1x. The share price has changed and this has changed the riskiness. It is dangerous to say that volatility is an indicator of its current riskiness."
Mundy adds that volatility can be a poor indicator because it doesn't take account of the outcome if markets hadn't moved that way. For example, a value fund can look volatile in a growth market and vice versa. This is particularly true of short-term volatility, which will be affected by hedge funds and other short-term traders in the market.
Secondly, there exists the myth that income-generating funds are necessarily 'safe'. Income does give some protection against the market, but there has been an assumption that all income-generating products - particularly split caps and precipice bonds - are cautious investments. If the headline income rate looks too good to be true, it probably is.
Gary Potter, co-head of the CSAM Multi-Manager team, says: "There is a misconception that cautious means no risk. You need to take some risk to generate income and capital over time. If you invest for five years, the chances are that you'll get your capital back. Cautious does not mean no equity. The real risk is in being out of equities. The hangover from the bear market is that there are investors who believe that they should only invest in corporate bonds and this is the biggest danger if you want to grow capital over time."
Also, there is also the myth that the use of derivatives increases the risk on a fund. Derivatives have a reputation of being racy, complex and dangerous. And in some cases this has been true. However, more often than not, derivatives are used as a risk management tool.
Mundy, for example, is willing to use options to protect the portfolio when there are short-term movements in the market on which he wants to capitalise. This should ultimately reduce risk rather than increase it. The new Non-Ucits Retail Schemes (NURS) can make limited use of derivatives and most fund managers are using these for risk management rather than profits.
So if cautious does not mean low volatility, income, no equity and no derivatives, what does make a cautious investment? It depends on the time-frame, on the blend and on the investment process.
Potter says: "Cautious to me means being less aggressive in the equity allocation and generating a balance between the stability of income provided by a corporate bond fund with the long-term benefits of an equity portfolio. This is what we try and do in our Cautious Managed fund.
"There are also very important attractions in blending a portfolio and using uncorrelated assets. That said, I would caution against using property because the average 55 to 60-year-old already has a lot of wealth tied up in property. Equally, I would question how cautious distribution funds really are. The managers have to have 60% in fixed interest to get the tax credit and this does impinge on their total return capability."
John Husselbee, chief executive of North Investment Partners, agrees. He says: "Investors can diversify on many levels. They can diversify by investment class, but also by product and funds. The trouble with previous so-called cautious strategies was that people were invested into one asset class - for example, split caps or with-profits."
He adds: "Cautious investing has changed. In the 1990s it was all about sticking to benchmarks. Now the prevailing view is that you don't want to be stuck to a benchmark. Sticking to a benchmark clearly has limitations - cash is high risk relative to an equity benchmark. Investors are better looking at absolute risk as measured by standard deviation."
An approach like Mundy's has an in-built caution, because it is fishing in the cheapest areas of the market. While this might seem to introduce more risk, it means that each company has limited downside. The downside for a company where the share price has soared is more significant. But most importantly, Mundy is clear about his risk management system. Advisers should be satisfied that each fund manager in which they invest has a robust risk system in place.
It is relatively easy to establish what cautious investing isn't - it isn't no equity, it isn't no derivatives, it isn't low volatility and it isn't income. It is more difficult to say what it is, but overall, a genuinely cautious portfolio should offer a blend of non-correlated asset classes. Depending on the client needs, it should also offer stability of income and capital growth potential. Within those asset classes, each fund manager should have a well-defined risk management system. This should offer the best defense against the pitfalls of the market.
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