The managers say this is still the core scenario they are planning for, but the trust is carefully positioned for three other possible routes world markets could take.
Investors have become too complacent, and serious downside risks still remain, they warn. “It is a dangerous world when investors (the cynic might say speculators) buy and sell on central bank largesse rather than fundamentals,” they said.
“This situation is ultimately unsustainable and we need to tread carefully. The recent reaction to the Fed's comments on tapering QE shows how difficult it is to wean the addict off cheap money.”
“The likelihood remains that the punchbowl will be left out too long and this means that our core protection against monetary instability (index-linked bonds and gold) must remain in place; index-linked for the moderate (but still pernicious) scenario and gold (painful though it has been) for the more extreme scenario, where the ability of governments to honour their debts is questioned.”
“This may seem a dark picture but arguably we took two steps down the default path last year with the deliberations about changing the terms on which UK Government bonds were issued.”
“Fortunately, common sense prevailed and the proposed changes to the Retail Price Index, which were tantamount to a default, were thrown out.”
Ruffer Investment Company retains 5.4 per cent in gold bullion, and 27 per cent in index-linked bonds, even though the assets have done poorly this year.
Data from FE Analytics shows that UK index-linkers have lost 0.44 per cent, US inflation-linked Treasuries 5.91 per cent and gold 19.75 per cent.
Performance of assets in 2013
Source: FE Analytics
Russell and Baillie say that these assets offer protection in the case of their core scenario of an inflationary environment.
However, they acknowledge that they have been a drag of late, and say there are three other scenarios that investors need to prepare for and the manager has hedged his portfolio against.
“We need to ensure that this cornerstone of our asset allocation does not become our Achilles heel (even if it is only in the short term),” they said.
“How might this happen? Firstly, a deflationary scare would see this part of the portfolio suffer. We are light on deflation protection but feel that this risk is underwritten by central banks, who would be quick to step into the breach with another dose of QE or equivalent stimulus.”
“The second scenario is that central banks succeed in getting the growth engines going again and bond yields start to rise.”
“If the market believes that sustainable growth is possible then the 45 per cent we hold in equities should perform admirably and will make up for the fact that our inflation insurance policies (index-linked bonds) are not required.”
The worst-case scenario for Ruffer and for all investors is that QE is withdrawn too soon, the managers say, and this is also the hardest to prepare for.
“There is a third scenario, which could potentially hurt our carthorse credentials; the withdrawal of stimulus by central banks when investors do not believe that a recovery is sustainable,” the managers said.
“Protection against such an event is hard to find; bond yields would rise (including our treasured index-linked variety unless inflation expectations also rise) and equities would fall.”
“The asset allocation matrix, which many have relied upon for the last 15 years, to hold 65 per cent in equities and 35 per cent in government bonds would be dead in the water as both sides of the equation would fall in tandem.”
Investors had a taste of this scenario over the summer, when bonds and equities both fell as the world first digested the possibility of QE being wound down and interest rates rising.
Performance of indices since 22 May 2013
Source: FE Analytics
“The best protection we have found is to buy payer swaptions that rise in value as bond prices fall,” the managers said.
“These investments allow us to hold index-linked bonds, which we think are an intensely interesting long term investment, through short term volatility.”
“The swaptions have performed very well in the last few weeks of the period under review [the year to July 2013] when both equities and bonds have been falling.”
The portfolio holds 3 per cent in options, according to the latest factsheet.
Ruffer is a £338m safety-first portfolio that made its name in the tumultuous markets of 2008. The fund made 23.01 per cent in that year, fantastic returns when world markets lost between 20 and 40 per cent.
The cautious nature of the portfolio means it does underperform in sharply rising markets. It made only 2.11 per cent last year as the average global growth IT made 12.04 per cent, and it also underperformed in the rally of 2009.
Over the last two years the trust’s returns of 20 per cent are well behind the 34.03 per cent of its peer group average and the 42.66 per cent of the MSCI World.
Performance of trust versus peers and index since 22 May 2013
Source: FE Analytics
However, the managers say they are not at all concerned, and defending better in the down periods is the key to long term outperformance.
“Think of an investor who follows the market and one year loses 30 per cent and then makes 30 per cent the following year (as the UK equity market did in 2008 and 2009),” they said.
“Initially £100 would have fallen to £70 and then would have bounced back to £91 - the refrain of the prep school maths teacher holds true; -30 per cent followed by +30 per cent does not get you back to where you started.”
“The carthorse investor, who makes a relentless but unexciting positive return, say +10 per cent, would have ended up with £121 over two years - a full 30 per cent outperformance over the rollercoaster approach. The carthorse is what we aspire to be for our investors.”
“In reality it is never possible to produce perfectly consistent positive performance figures (Bernie Madoff being the exception) but we can get half way there by being fixated with not losing money - if we achieve this objective (a big 'if') the strength of compounding is on our side.”
“Last year we were mildly apologetic for flat lining and this year our return of +13.2 per cent [for the year to July 2013] is ahead of our long term average (+10.7 per cent per annum since inception) but the key to both these years was not to lose money when the going was tough.”
