SO, WHAT do we do now? After rising sharply over the past six months, the stock market has come off the boil. The FTSE 100 has fallen for the second week running.
Should we take profits or hang on in there? And if we hang on, what sectors or funds should we hold to give us protection against a more prolonged sell-off?
Investors, never having quite believed why stock markets have recovered in the first place, will be tempted to opt to switch into the “cautious managed” fund sector as the best protection should markets experience a prolonged correction. How do the two portfolios typically compare?
For this article I have turned for help to independent financial adviser Tom Munro. I asked him to set out two model portfolios – one aiming for capital growth (often referred to as “aggressive”) and one for the investor who wants to sleep at night (“cautious managed”). This, with the help of the Nucleus fund platform, he has ably done.
One striking difference is immediately obvious. The “cautious managed” portfolio has substantial holdings in UK gilts and overseas government bonds, and also holdings in UK corporate bonds and overseas fixed interest. In fact, if you tot all these up, they account for almost 40 per cent of the “cautious” portfolio, not including the 6 per cent cash account holding. Very cautious indeed. By contrast, the “aggressive” portfolio holds just 3.5 per cent in UK gilts and no overseas government stock or corporate bonds, with the remainder of the portfolio in UK and international equities. This portfolio is deemed exposed to greater volatility and the prospect of capital loss.
On charges, Tom says that for the cautious portfolio the total annual fee comes to around 1.03 per cent a year and for the adventurous version 1.31 per cent – good value, he points out, given that the portfolios are realigned automatically each quarter in line with economic conditions.
But of late a worrying paradox has set in. The “cautious managed” portfolio could well prove more exposed to capital loss, while the “aggressive” fund offers the better prospect of capital protection. What explains this contradiction?
Over the past five years, investors stampeded into corporate bond funds and government bonds as interest rates were cut to ultra-low levels. Corporate bonds offered yield attractions, while government bonds, though yielding little, were seen to offer greater stability and capital protection.
But the labels “cautious” and “aggressive” could now prove misleading. There are growing signs that interest rates are on the rise as central banks, led by the US, begin to contemplate an end to quantitative easing. Just such a hint recently by US Federal Reserve chairman Ben Bernanke contributed to the sharp market sell-off two weeks ago.
Last week saw American investors selling out of US Treasuries on fears that a strengthening recovery could prompt the Fed to end its $85 billion-a-month monetary stimulus programme.
Last Saturday, the Financial Times reported that higher yields for government debt in the US, Japan, Germany and the UK hit prices for corporate and emerging market debt and also US mortgage-backed bonds. Benchmark UK yields last week rose back above 2 per cent for the first time since February, while yields in Germany and Japan have moved sharply higher.
Bond market futures are now said to be pricing in an increase by the Fed in official US rates in late 2014. Previously traders had not been expecting a rise in rates much before the summer of 2015.
What this does is to open the prospect of a sharp and prolonged fall in government stock and corporate bonds. It is not at all improbable that the yield on ten-year gilts could rise to 5 per cent over a three-year period. This could be accompanied, for those who calculate such things, by a loss on gilts of around 20 per cent, peak to trough.
Thus, far from proving the asset class of relatively lower risk and greater capital protection, cautious funds biased towards government stock and bonds may well prove the opposite. This does not mean, of course, that aggressively positioned equity funds will perform much better – equity markets have also moved lower on the prospect of an end to a most extraordinary period of rock-bottom interest rates. But it sounds a warning bell to those who believe “cautious managed” will be the safer haven in purports to be.
However, what Tom Munro’s two examples provide is a reminder of the importance of diversification – not just by asset category but also by geography and across sectors (financials, industrials, health care, consumer staples, minerals etc).
One final point on the “cautious” v “aggressive” polarisation. What investors should be looking for in today’s uncertain conditions is a balanced portfolio – one that does not readily fit the conventional stereotypes of “aggressive” and “cautious” but which provides diversification without such a strong bias towards one asset category or another.
This “third way” would seem the appropriate choice for most people – while maintaining an ample cash reserve for buying opportunities ahead.