Martyn Ingram of The Investors Partnership suggests a portfolio that will take advantage of market rises while protecting you from the inevitable downside
If you had invested in Gartmore UK Equity Bear at the beginning of May and stayed invested over the following weeks, then you would have been in a retail fund that has profited from the recent change in stock market conditions.
The fund, which was originated by Govett many years ago, was one of a small number that made profits as the stock market suddenly declined. If you still feel bearish about the outlook for equities, then funds like Gartmore UK Equity Bear will merit your consideration; if the stock market goes into a prolonged decline then the fund could end up being one of the best-performing retail equity funds this year.
Most retail investors would not bet on a prolonged bear market, and even those that do might not choose to buy and hold a fund like Gartmore UK Equity Bear. A feeling of change is in the air - it has been a great three years but now investor optimism is evaporating fast. Over the last three years, investors have got used to making money as everything has been going up, regardless of merit. But the tide has now turned, and the change in investor attitude is going to be a major negative factor for the market in the months ahead.
Handle with care
One knock-on effect of this change in investor attitude is that planned new issues will now be pulled, or deferred until they can be more reliably priced for the stock market. While investors may be shying away from risk taking, there will be numerous opportunities to make money. However, most retail investors will not be able to exploit the shorter-term opportunities through traditional retail funds.
There are many ways to handle a bear market, especially as stock market prices tend to trade either sideways or upwards for most of the time. Investors can be easily fooled into believing that a bear market has come to an end long before the bottom of the market has been reached, but they learn fast when severe market falls offset the stock market gains they benefited from.
Fund managers with a bearish outlook on the market have had a tough time for most of the last year. They had little chance of achieving first or second-quartile performance when the market was going up, and they will not have been immune to the recent market falls.
Bearish managers can be skilled at protecting investors from the worse of any losses when the market falls, but the mandates of most of the retail funds they manage require the funds to be mostly invested in the market all of the time, regardless of market conditions. Those bearish managers who manage traditional equity funds can do little more than limit the downside.
Evidence of this is all around us - just take a look at the day-to-day performance results of most retail funds over the last month.
On the bright side
There is some good news, however. Funds that can defend the downside are becoming more readily available to retail investors. These include total return funds, including bond funds that use derivatives to protect against short-term losses. The funds available generally fall into two camps: those that target relatively low rates of return, even in bull market conditions, and those that rely on the fund manager making a defensive market call at the right time.
Bear markets do not last for ever, but they can be painful. For example, the 2000-2003 bear market resulted in UK equity investors losing about 6% in 2000, 13% in 2001 and 23% in 2002, but these figures are magnified to 9%, 14% and 25% in real terms, after taking account of inflation. The experience of losing money for three years is still clearly imprinted on the memory of many retail investors. Most were still very bearish when the bull market returned in the spring of 2003, and some investors only started to regain confidence to invest in equities once the FTSE 100 broke through 5000 in February 2005.
The UK equity bear markets in the 1980s and 1990s were shorter-lived affairs than the 2000 to 2003 one. The 1987 crash caused investors to lose money, but over the calendar year as a whole, investors ended up making money. In 1990, investors lost about 10% of their money (equivalent to more than 17% after taking account of inflation), and in 1994 they lost about 6%. Investors made money in UK equities for most of the 1980s and 1990s but the bear markets were painful.
If you believe that 2006 is going to be a down year for the equity market then you should probably not invest in equities as even profitable, well-managed companies will be dragged down with the market.
Keep your options open
There is the option of putting together a portfolio that participates in the market rises when they occur, while also providing protecting against much of the downside. If you believe the bear market is going to continue for some time then this portfolio is not for you. However, if you believe that the longer-term direction of the markets is still upward, but you want to take less risk, then individual holdings in the portfolio below may merit your consideration.
My first choice of fund is Scottish Widows Safety Plus. This is a good fund to dip in and out of, but be wary when the current price is well above the safety-net price. If you are not familiar with this fund and its safety-net feature then it could be worth a little research.
My second and third choices of fund are Baring Directional Global Bond and Threadneedle Absolute Return Bond. Baring Directional Global Bond is more a currency fund than a bond fund. It got off to a poor start at launch, but it merits investor attention at this time. Threadneedle Absolute Return Bond is a relatively new fund (it was launched in September 2005). Its target is to outperform cash by 60% before charges and tax, and it aims to offer positive returns in all market conditions.
My fourth fund choice is MFM iFunds. It is difficult for prospective investors to get information about this fund, but this should change once the fund is one year old. My next choice is Ruffer Total Return (formerly known as Ruffer Income), a fund that targets absolute returns and low volatility and is managed using a capital preservation philosophy.
Lastly, there is one region of the world that should offer investors substantial investment returns over the years ahead - the Far East. For those prepared to invest in these markets at this time, I have included a value-orientated equity fund, Lincoln Far East. In a bear market, investors in the fund will lose money, but if markets move sideways (or even up!) then this fund could generate positive returns. If, like me, you believe that the Far East is an attractive investment region, then Lincoln Far East is worth serious consideration.
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