While capital preservation is pretty high up the list for most investors, there are differing levels of risk and return to choose from and an assortment of products that reflect these measures, says Chris Salih. No-one want to end with less than they invest, so caution is wise, although there is no point in stepping onto the investment stage if you do not aim to make returns
Honesty may traditionally be the best policy but, after the past half a dozen years, advisers may be forgiven for thinking caution runs it a very close second. Indeed, while the rest of the world appears infatuated with gambling, investment often seems focused simply on safety and responsibility, thereby ensuring clients have a nest egg to retire on or that those school fees are reassuringly secure.
No-one could really argue capital preservation has not been the order of the day. But does that mean everyone has to go down the same route as George Eliot's famous protagonist Silas Marner and hide all their money underneath the floorboards? Or can there still be more to investment than merely gazing at a pot of gold that's growing at a snail's pace?
Gambling with one's finances means different things to different people, with risk and return usually at the heart of the issue. Some people are happy to risk £20 playing roulette, knowing that despite whatever bad luck the croupier brings them the worst they can do is end up with very light pockets. Others aren't happy unless they are risking it all, knowing that if the gamble pays off they could be set up for life.
The trouble with that second view is, rather like the Russian prisoners who were forced to play Russian roulette in the 19th century, investors are generally aware there is every chance their gamble could easily end up a nasty mess.
As with all things that grow rapidly through demand, the industry has been quick to satiate investors' needs by offering a plethora of new vehicles that meet both goal and risk parameters. But what exactly do these vehicles entail?
You would expect many such funds to offer some portion of fixed interest but, considering the contribution equities tend to play in portfolios over the years, ignoring the asset class over the long term is likely to be missing a trick. So what is on offer to advisers and their clients that can tick both risk and reward boxes?
Though some may argue Marner's attitude actually had some merit - though remember even he had all his money stolen - perhaps a logical starting point is for investors to place their money in cash funds, which essentially do what they say on the tin. But then what is the difference between that and placing your money in a bank or building society?
"Not much," is the short answer from Justin Modray, an investment adviser at Bestinvest, who describes cash funds as "so static there really is no value in them". "The fact is they are seldom used, with the only viable reason for employing them possibly being transferring unit trust money to cash before reinvesting it," he adds.
"In fact, I can't think of any of our clients who have got a cash fund. The crux of it is that the best banks and building societies offer better returns than cash funds with the icing on the cake being some sort of golden carrot to attract customers."
Marcus Brookes, deputy head of multi-manager at Gartmore, takes a similar line. "A cash fund yielding between 4.5% and 5% is doing little more than matching inflation," he says. "They may be safe havens but nobody aged 21 is going to be able to safely retire at 65 on the back of a cash fund."
For those with loftier ambitions, a fixed income fund is the most obvious choice when share markets are performing poorly. However, despite their domination of the market between 2000 and 2003, as an asset class bonds have suffered badly over the past few years as equities have prospered. Case and point is the fact that none of the fixed income funds in the top 20 all-fund performers during that bear period has managed to retain any semblance of that outperformance in recent years.
The safest fixed income investment tends to be gilts - bonds issued by the UK Government. Unlike some developing nations, the likelihood of this country's Government defaulting on a loan is minimal but the downside is, as you'd expect, that after you take away a gilt fund's annual management charge, the coupon is worth little more than cash.
Moving a bit further up the risk scale, there are of course an assortment of fixed income funds investors can sink their teeth into. These range from investment grade portfolios, which tend to offer a higher yield than gilt funds by investing in the debt of quality companies, to high-yield bond vehicles that invest in the debt of companies that are not so stable.
"If an investor was starting out, I'd recommend investment grade bonds - simply because of the higher income on offer in comparison to gilts", says Bestinvest's Modray, who is also a fan of strategic bond funds as they have the flexibility to follow the course of the market.
"Look at the Artemis vehicle run by James Foster or the Threadneedle version managed by Barrie Whitman," he says. "They use a whole range of fixed income options to achieve their returns - gilts, investment grade and high-yield bonds. The problem is, to do this, a manager needs a massive skill set - resulting in a few who can come at a premium.
One result of this drive towards capital preservation has been the rise in the popularity of the absolute and target return vehicles (see also page 32). As with bond funds, these can also take a number of forms but the mindset is that the majority - although by no means all - look primarily to ensure capital is not lost before adding to it through exposure to different markets and asset classes.
ABN Amro's Capital Protected Lifecycle funds, for which the group recently received regulatory approval to run in the UK, are an interesting example of these multi-asset vehicles. The six-strong range is a structured product designed to offer a risk-averse option to meet future client commitments, with the maturity date segmented over five-year periods from 2010 to 2035.
As the maturity date approaches for each portfolio, the underlying investments will reduce in risk to protect existing returns, by focusing on cash, fixed interest and equity derivatives. So while the 2010 version may only hold as little as 25% in equities the 2035 fund may for the time being go as high as 85%.
"At the end of every month we look at the net asset value of each fund and, if it's above the current value, we will lock in the gain by increasing the exposure to the fixed income component," say Lucien Carton, a global product specialist at ABN Amro. "Once that net asset value is locked in, it cannot be lowered again."
Another take on locking in value comes in the shape of a trio of Close Brother portfolios - European Escalator, UK Escalator 95 and Close World Escalator - which hold the top three positions in the Standard and Poor's nine-strong Guaranteed/Protected sector over a three-year period.
"Although there is a need for such products, the worry is we will end up with too many 'me too' offerings," says Ian Shipway, a financial adviser at Thinc Destini. "Over the past few years too many advisers were sitting with their clients and telling them they had 20% or 30% less capital than the year before, so something had to be done and these funds are the biggest result of this."
While capital preservation products are insulating themselves from potential losses, managers who are making use of all the flexibility the Ucits III legislation grants them also run the risk of isolating investors from potential gains.
Multi-manager - more on which can be found in this month's RealAdviser Inquiry on page 36 - also offers some good options for those seeking to keep their capital and still make a turn on their investment. Designed as a risk diversifier, it allows advisers the opportunity to outsource to specialists in the arena, thus allowing them to focus more on client relationships.
As highlighted in last month's Asset Allocation piece from Old Broad Street Research, MitonOptimal is a good example of a multi-manager that sets great store by capital preservation. From 1999 to 2002, two of the 13 multi-manager funds that posted positive returns fell under the group's umbrella. Miton Special Situations has also proved itself a top performer in positive markets.
"We try to put together as many non-correlated assets as possible in order to protect our investment in the more brittle of markets," says Tom McGrath, a fund manager at MitonOptimal. "So, if the US is tanking, then gold is generally performing well for us.
"A perfect example of this is a structured product we just bought in Barclays, which will double in value if the US market falls. As for the Special Situations fund, we were lucky enough to spot the bear market ahead of time and reduce our exposure to equities to below 50%."
Without doubt, the most popular multi-manager sector at present is the Cautious Managed grouping, which has boomed in the wake of the bear market and the collapse of with-profits. Investing in both equities and bonds, such funds are seen as ideal diversifiers of risk. "They allow managers to deliver absolute returns over the medium to long term by diversifying the portfolio between equities and bonds with asset allocations following market trends," says Gartmore's Brookes.
Adds McGrath: "There is a real place for what they offer in the market. They should hold between 40% and 60% in equities when they are performing in order to ensure the fixed interest element remains central to a fund's performance.
"Many of these funds were being formed right in the middle of the equities boom in the late-1990s, and many managers got it wrong by overexposing their balanced portfolios to equities by as much as 85%, therefore nullifying the presence of fixed interest. That lack of protection, as we know, ultimately led to problems."
So are there any 'straight' equity funds that look to defend an investor's initial capital? "The Odey funds tend to keep a close eye on capital preservation as does the Lincoln Far East fund, which stands out in particular," says McGrath. "It tends to be the boutiques, however, that have a stronger appetite or this, as the bigger groups are far more benchmark-constrained."
Cautious types looking to invest over a longer timeframe may also delve into the growing commercial property sector. As demand for property, in both the commercial and retail spheres, tends always to be constant, it is an ideal lower-risk investment that has passed into the mainstream in recent years.
"Commercial property as a investment has become so popular, the problem is there's only so much further it can go," says Bestinvest's Modray. "On the upside, commercial property means you've got tenants with 20 to 25-year rent agreements where the rent can only go up."
New Star has added a twist to commercial property exposure by launching its Tri Star fund, a multi-asset vehicle that invests in commercial property alongside equities and bonds. With asset allocation managed by Gregor Logan, the fund invests approximately a third in each asset class with Stephen Whittaker (UK equities), James Gledhill (bonds) and Roger Dossett (commercial property) in charge of stock selection.
As with most things in life, risk and return mean different things to different people and yet investors should at least be in agreement that the one thing nobody ever wants is to end up having less money than they started with.
That said, while Silas Marner's preferred option of keeping everything close to one's chest - or under the floorboards, as the case may be - does offer the more cautious among us the prospect of a good night's sleep, the fact remains there is little point investing unless you want to make some kind of return. Just one more area where the adviser's knowledge of the available appropriate financial solutions comes to the fore.
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