Bill Jamieson: When '˜cautious' funds come into their own

Cautious funds have powerful allure, but their very nature can often make them too hesitant, writes Bill Jamieson.

I have never been a great fan of “cautious managed” funds. They are a hugely popular sector of the investment management industry. Professional advisers and pension fund trustees love them: you will never get fired for putting clients in a cautious fund.

But straddling as they do fixed interest and equity markets, such funds are neither fish nor fowl. They are equity funds with no promise of performance and fixed interest funds but with an exposure to downside risk. If you are nervous of equity markets, why not simply hold more cash, or invest directly in gilts or fixed interest stocks? It’s cleaner, it’s simpler and cheaper in fees and costs. But my bias could now be subject to challenge. As stock markets have been grazing all-time highs in recent weeks, investors have become apprehensive. And the current news flow – geo-political tensions in the Middle East and Asia, deadlock over Brexit, political vulnerability here in the UK – makes that apprehension look well merited.

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Private investors are already hedging their bets over the outlook for markets. Latest figures from the Investment Association show fund inflows have hit another record high, suggesting that stock market euphoria is sweeping all before it. But a closer look at the figures reveals a different picture.

Inflows into funds and trusts did indeed break an all-time record of £5.6 billion in September, taking total sales for the first nine months of the year, and making 2017 a record-breaker already with three months still to go. But a look under the bonnet reveals that the majority of the money invested has gone into fixed income funds. These attracted £4.9bn in September, accounting for 87.5 per cent of the monthly total. Much of this money has flowed into strategic bond funds, which in theory have the flexibility to shelter investors from the worst ravages of rising rates on fixed income prices – if the manager makes the right calls. These attracted £985 million of sales in September making it the top selling sector, just down on the £1.1bn seen in August. By contrast sales of UK equity funds have been poor.

UK equity funds saw net outflows of £103 million in September while UK All Companies was the worst performing sector with net outflows of £111 million. “UK avoidance” has been one of the distinctive features of the UK fund management industry this year. “Steer clear” areas have included big store retailers, banks (again), most industrials, drinks and leisure stocks. Globally, a third of fund managers are ‘underweight’ UK stocks, their most bearish stance since the financial crisis. Says Steve Davies, manager of the Jupiter UK Growth fund: “It is hard for me to think of a less popular area anywhere in the investment universe at present than UK domestic stocks.”

Citywire reports that contrarian and value-focused fund managers are excited about the rock-bottom valuations of UK domestic stocks, which are trading at their lowest levels since the financial crisis. UK domestic stocks are trading at around a 25 per cent discount to the wider UK market, close to financial crisis levels when they traded at a 30 per cent discount. “Investment sentiment,” argues Jupiter’s Davies, “towards the UK is now as bad as it was in 2008 when much of the UK banking system was on the verge of collapse.

“This appeals to my contrarian instincts and, in some ways, reminds me of how low sentiment towards emerging markets had sunk a couple of years ago.” And Martin Walker, manager of the Invesco Perpetual UK Focus and UK Growth funds, also highlights the strength of investor bearishness over domestic UK stocks. “Valuations for UK domestics,” he says, “have de-rated to global financial crisis lows, supporting a view that even a modest improvement in the outlook for the UK, sterling or the consumer may be enough to prompt some better performance.”

Some argue that UK retail holdings like Sainsbury and Marks and Spencer offer the most value, with the shares suffering from a Brexit-induced pessimism over the UK economy.

Now all this may sound too much like wishful thinking for some. This is where cautious managed funds have a powerful allure. The £2.1bn Investec Cautious Managed Fund has more than 30 per cent of its portfolio in cash and fixed interest. The £2.2bn Henderson Cautious Managed fund is not far behind, with 25 per cent in cash and fixed interest.

They would be ideally placed to take advantage of a market correction and jump in to buy as prices have fallen. But here’s the puzzle: by being obliged to be cautious, would they dare take advantage?