‘Cautious’ funds backfire as high proportions are risked in equities

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Anxious investors shifting money into funds purporting to protect them from market volatility are putting themselves at risk of losses even as they head for shelter, evidence suggests.

Private investors and pension savers hold billions of pounds in funds marketed towards those with a cautious attitude to risk. But many of the funds expose investors to a greater potential for losses than they would expect.

The latest warnings over the dangers of funds branded as being suitable for cautious-minded investors came after Royal Bank of Scotland shut down two funds promoted as offering protection against stock market volatility.

The £50 million Volatility Controlled Balanced Managed and the £49m Volatility Controlled Cautious Managed funds, launched in January 2011, were closed after posting poor returns that fell short of their peer group. Many (but not all) investors in the funds were left with losses having put their money in with a view to benefiting from risk-managed returns.

The taxpayer-backed bank had claimed the funds were more transparent than the usual cautious or balanced managed fund and that it had taken extra steps to manage volatility. The two funds invested in bonds, equities, property shares and commodities, with weekly rebalancing in accordance with stock market movements in order to maintain their risk profile.

“These types of funds were designed to protect investors from the worst vagaries of the markets with positive outcomes in good times,” said William Hunter, of Hunter Wealth Management in Edinburgh. “In practice, however, by selling out after the damage was done and then remaining in cash and bonds and subsequently missing any rebound in markets, the damage was guaranteed to be felt by investors in their pockets.”

RBS’s volatility controlled balanced managed fund closed 8 per cent down since launch, compared with an average 0.2 per cent loss in its peer group over the same period. The cautious managed fund was down more than 10 per cent, whereas the average fund in its sector was up 5 per cent.

Barry O’Neill, investment director at Carbon Financial Partners, said: “I remember the RBS funds being launched and I thought then that these were simply the musings of the marketing men whose job it is to churn out shiny new products. I could see no real demand or need for the funds at the time.”

The RBS move came months after the rebranding by the Investment Management Association of what used to be its cautious and balanced managed fund sectors as the Mixed Investment 20-60 per cent Shares and Mixed Investment 40-85 per cent Shares respectively.

Funds in the cautious managed group can invest up to 60 per cent of their assets in equities, with at least 30 per cent of the remainder in fixed interest and cash. Those in the balanced managed sector can hold up to 85 per cent in equities.

“Under their previous guise of balanced and cautious managed funds, they were anything but balanced or cautious,” said O’Neill. “I have never met an investor who described their views about investing as cautious, but who was content with 60 per cent of their money riding on the fortunes of the stock market.”

Investors hold some £20 billion in the funds, offered by providers including high street banks. Despite the rebranding of the sectors in which they’re housed, many still carry either the cautious or balanced prefix.

And the dangers haven’t gone away, according to O’Neill, who expressed concerns over the high level of equities in many of the funds.

“Your fund could have anywhere between less than half and up to virtually all of your money invested in the stock market. You’d have to be particularly trusting to live with this potential range,” he said.

One outcome of the rejig of the two sectors is that a fund with a 50 per cent share content could sit in either.

“You really need to look carefully at the fund’s objectives and the benchmark it intends to measure itself against,” said O’Neill. “The most important task when considering any investment is to properly understand what the underlying assets are, so you can take a view on the likely performance and equally importantly, the potential risks.”

The problem for investors is exacerbated by the fact that managers have the flexibility to change their asset allocation, as long as it stays within the broad parameters of the funds (i.e. 40 to 85 per cent equity and 20 to 60 per cent equity).

Also look at the recent performance. It shouldn’t dictate your decision on its own. A fund’s performance over, say, five years, helps give an idea of how it has fared in various market conditions.

Over that period the typical cautious managed fund (in what’s now the 20-60 per cent sector) is up 9 per cent. Yet while the top fund (the CF Ruffer Total Return) has produced a 54 per cent return over five years, almost 20 funds have posted losses, some by over 10 per cent.

The disparity in performance is similarly stark in the 40-85 per cent sector, where the average fund is up just 5.3 per cent over five years. There, the top return of 37 per cent – the McInroy & Wood Balanced fund – compares with -17.3 per cent at the other end.

Matters are made worse by often high charges, which can also vary widely between different funds in the sectors. Some, according to O’Neill, are “ridiculously high”.

“This is in no small part due to the massive marketing spend of the serial product creators. Investors need to wake up to the fact that every pound in charges is a pound they no longer have in their investment fund,” he said.

So what’s the alternative for those wanting some volatility protection in their investments?

Advisers generally recommend building a diversified portfolio that accurately reflects risk appetite and capacity for losses.

“By using a range of low cost or passive tracker funds and rebalancing them from time to time to keep them on track, an investor should have a realistic expectation of how their money will work and more importantly be able to have a good night’s sleep, not worrying about it,” said Hunter.