Three ‘all weather’ strategies for volatile markets

Rob Morgan takes a look at some options for investors wishing to moderate their investment risk.

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  1. Rob Morgan

Stock markets have surged since the end of March, driven by the actions of central banks pumping money into the system, as well as government’s efforts to keep individuals and businesses affected by the Coronavirus lockdowns afloat.

Key to the performance of shares, though, has been the continued rise in government bond prices (and the collapse in yields). The projected returns from bonds tends to be the benchmark for pricing almost all other assets and high valuations in this area can lead to high valuations elsewhere. Ultra-low interest rates and bond yields mean investors see less difference between the value of money today and the value of money in the future, which essentially serves to enhance the value of future profits – there’s no need to ‘discount’ them by so much.

At Charles Stanley, our Investment Strategy Committee has flagged the growing gap between the prospects for earnings for much of the global economy and equity valuations that have been boosted by exceptionally low bond yields. The gains in global markets have largely been concentrated in sectors and companies that can survive and thrive in the current difficult economic conditions, especially those that use or provide digital technology. This progressively lopsided nature of returns from markets also needs to be viewed with some caution.

US election uncertainty

The upcoming presidential election adds further uncertainty to the mix. The US is currently at a crossroads. The choice between President Trump and candidate Biden is a stark one, which will result in very different outcomes. A Trump Presidency means a belief in cheap fossil-fuel energy, a larger US oil, gas and coal sector, lower taxes, less regulation of business. A Biden presidency would mean higher taxes, more regulation, a major change of direction on energy – with a big switch to renewables – and hostility towards carbon-based fuels, and a further move to higher welfare and state health spending.

As it currently stands, a Biden win seems the more likely outcome. The polls have consistently shown him with a decent lead in the national polls, although in the crucial swing states polls have tightened – and many are now too close to call. There is a possibility that the Democrats may control the three branches of the US Government under Biden (White House, Senate, House of Representatives), and this could mean some damage to share values, as could a ‘contested’ election scenario.

Some hope there would be a very large fiscal stimulus to offset the full Biden agenda, with large tax rises, more regulation of large companies but given the current high valuations there would seem to be scope for a market sell off in this scenario.

Covid concerns

On top of the US election and any further events that might unfold through the UK’s exit from the EU, we face the prospect of a long winter ahead that will see further virus-related economic damage. Markets are hopeful for a working vaccine by February. That is possible with plenty of candidates in clinical trial but is far from certain given the difficulty of finding effective vaccines against flu and the problems in finding enough production capacity globally. If there is a credible vaccine, the sectors badly damaged by the pandemic are likely to rally. Without it, we will continue to live in an online world for longer, where sectors and companies harnessing digital operations might continue to outperform.

Defence from diversification

Investors’ first line of defence against these uncertainties is diversification. Taking no investment risk at all through holding cash leads to poor long term returns, but owning different sectors, geographies and types of asset can help reduce risk in an investment portfolio and ensure you are not overly reliant on one area or on particular economic circumstances. If one of the investments is performing poorly another could be making up for it, meaning a less bumpy ride for your portfolio overall. Over the long term each can still contribute towards performance – assuming they are well chosen – thereby improving the return achievable for a given level of risk.

A well-diversified portfolio, where constituents perform differently rather than moving mostly in tandem, is a simple concept but not necessarily an easy thing to achieve. Sometimes assets that appear to be different can end up being aligned to some of the same trends. Diversification only works if the investments aren’t too ‘correlated’ with one another.

Although equities have historically provided the best returns over long periods (five years plus), using other assets such as bonds, property, infrastructure and alternative investments can reduce risk while still generating decent performance over the long term. Here’s some possible routes to diversification for investors prepared to take a moderate amount of risk. Including these in a portfolio could help even out the volatility of other, riskier investments but offer superior returns to cash over the longer term; although all investments can fall as well as rise and you could get back less than you invested.

Strategic bond funds

Bonds can offer investors opportunities for income and the benefit of diversification. Investing in bonds is still riskier than cash, much riskier in the case of higher yield bonds, and the price of bonds fluctuate based on interest rates and creditworthiness. But for investors willing to maintain some risk, they may be a good middle ground between equities and cash.

In this uncertain, changeable environment, being able to move between different parts of the bond market is potentially valuable, and investors may wish to consider the use of fund that can do this for them. There are a number of funds in the Investment Association (IA) Sterling Strategic Bond that aim to make these decisions on an ongoing basis with the aim of superior performance – though this is not guaranteed.

Managers are typically free to invest in government, corporate and high yield bonds in whatever proportions they wish. This means funds can vary their mix of investments considerably over time, for instance switching from predominantly investment grade to predominantly high yield according to how the manager views the environment. For instance, high yield bonds tend to do better than government and high-quality bonds when the economy is doing well and interest rates are rising, but the reverse is true if the economic outlook darkens.

Janus Henderson Strategic Bond, part of our Foundation Fundlist, is one option in this sector.   Managers John Pattullo and Jenna Barnard aim to add value by taking strategic asset allocation decisions between countries, asset classes, sectors and credit ratings. The flexibility of the mandate, as well as the depth of resource and the experience of the managers affords them the chance for outperformance irrespective of the prevailing market conditions.

Multi-asset funds

Multi asset funds offer a diverse portfolio in a single fund, spread among various underlying investments in different areas. This means they are less reliant on specific investments or areas performing well.  Multi asset funds can therefore offer ‘ready-made’ portfolios in a single fund, or they can help make up the 'core' of a portfolio around which other investments can be added.

Charles Stanley’s range of multi asset funds mix different asset classes including shares and bonds, as well as other areas such as targeted absolute return or infrastructure funds. If you are looking to invest but don't want to monitor or rebalance a portfolio, they could be worth considering.

For those wanting a conservative approach but are still able to tolerate some larger short-term fluctuations in value in order to achieve the potential for better long-term returns, the Charles Stanley Multi Asset Cautious Fund offers a portfolio that caps exposure to shares at 60%. However, it will be materially lower than this unless our Fund Managers are exceptionally positive about market prospects. More often it will have a modest bias in favour of cash and bonds over equities for a medium-low risk outlook.

Targeted absolute return funds

By using sophisticated investment techniques such as shorting (profiting when prices fall) these aim look to make modest but more consistent gains with smoother performance than traditional funds. They are also designed to be more resilient during market turmoil.

Despite sharing a similar broad objective, funds in the sector vary considerably in terms of investment approach. Some concentrate on one asset class, whereas others blend a variety of assets or strategies together. Funds also differ in terms of the amount of risk taken with some aiming to eke out modest returns, with other prepared to be more aggressive. This means each fund needs to be considered on its own merits and making direct comparisons with others or the peer group average may not be particularly useful.

Some funds in the sector have little correlation to the main asset classes, so they can provide useful diversification. Other funds in the space have a greater correlation with stock markets, aiming to capture a portion of the returns from equities in a risk-controlled way.

One option in this sector is BNY Mellon Sustainable Real Return. The fund comprises a ‘core’ of assets chosen to generate attractive long-term returns, which are offset by stabilising, lower-risk assets and hedging positions to dampen volatility and to provide downside protection. The core is invested in shares of high-quality companies with predictable and stable cash flows, alongside bonds which the managers believe offer value. Among the offsetting positions are typically gold and US Treasuries, while the tactical use of ‘put options’ serve to help protect the portfolio against a significant fall in the market.

The managers use a thematic approach to investment decision making, which focuses on identifying long-term structural changes impacting the global economy. This includes demographic shifts, the growing demand for healthcare and environmental change. Their analysis provides the basis for the views taken on asset classes, sector positioning, stock selection and risk. The fund may appeal to investors looking for modest capital growth while aiming to control volatility.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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