Radically changing cautious portfolios is “now vital”, according to Psigma Investment Management, as years of distorted markets mean that assets which were once perceived to be low-risk can no longer be considered so. 
Recent months have seen a number of fund managers warn that cautious funds are heading for difficult times, with the likes of Schroders’ Marcus Brookes, Rathbones’ David Coombs and Brooks Macdonald's Jonathan Webster-Smith saying it is becoming "exceptionally hard" to allocate money in a cautious portfolio.
Last month, Hawksmoor’s Ben Conway told FE Trustnet that “never, ever” been harder to build a cautious and diversified portfolio, adding: “You cannot lose sight of fact that the current environment is unprecedented. These are ridiculous times, absolutely ridiculous.”
Tom Becket (pictured), chief investment officer at Psigma, agrees that it has never been more difficult to be a cautious investor.
“In fact, the term ‘cautious’ is now basically prehistoric, as the ravaging and distorting effects of central bankers have eliminated the return potential of most traditionally cautious investment choices,” he said.
“The valuations of the vast majority of cautious assets are now prohibitively expensive. More importantly if you, like us, consider your key risks to be losing money and not keeping up with inflation then cautious investors might well be surprised by just how risky their portfolios are.”
“Investors need to refresh their concept of risk in light of the major distortions across global asset markets particularly in fixed interest markets, but also in all traditional lower risk assets.”
Psigma believes that there is a significant possibility of major losses in some assets that investors “mistakenly” think of as being low-risk. This is because years of money-printing have pushed bonds, high-quality companies and prime property to extreme valuations as more and more investors flocked to them in an indiscriminate search for returns.
Becket argues these assets are now at such valuations that “it is hard to see any further upside”. He believes that any changes to interest rates, the path of economic growth or the likelihood of renewed inflation will create serious challenges to the assets that have done well over recent years.
“If interest rates and inflation were to return to levels of circa 3 per cent, as we expect in the medium term, both absolute and real returns from typical cautious strategies could look measly and there are obvious downside risks to many asset classes in such a scenario,” he said.
“For evidence one only has to see the damage wrought to certain markets in February of this year, caused by a temporary more hawkish reassessment of US interest rate policy, to see how longer term trends might play out.”
As the graph below shows, government bonds – represented by 10-year-plus gilts – posted significant falls in February, while equities ground higher. This led to meagre returns among cautious funds.
Performance of indices and sector in Feb 2015
Source: FE Analytics
Other assets perceived as being ‘safe’ were also hit hard in February. As Becket said: “It might well be that the volatility and losses we saw in US treasuries, gilts, investment grade credit, utilities and REITs in February were the opening salvoes of a violent war in such markets.”
“If nothing else, it was a timely and overdue reminder that such assets can no longer be realistically considered to be low risk. We believe that shifting one’s cautious asset allocation mix is now vital.”
Having to avoid government and corporate bonds, which are the typical hunting ground the cautious investors but the assets Psigma expects to come off worst, seemingly offers few places to go. The firm believes the only answer is “a mixture of diversification and innovation”.
While bonds still have a place in portfolios, the allocation to government and high-quality corporate debt should be much lower than cautious funds have opted for in the past, Becket says. But portfolios need to pay closer attention to correlations to ensure that they are diversified in more ways that just asset names.
The chart below shows Psigma’s cautious asset allocation. More than half of the portfolio is in bonds, but the group says investors shouldn’t give up on the asset class, just “think differently”.
Source: Psigma
The hunt for yield
When it comes to the hunt for yield theme, which covers quality fixed-income and specialist credit, Psigma has moved most of its bond money from mutual funds to segregated mandates, as it wants more of a concentrated ‘credit specific’ focus and is sceptical about some of the holdings of giant bond funds.
It prefers funds that it has structured with management groups, such as TwentyFour Focus and Airlie Select Focus, which hold bonds to maturity rather than constantly redeeming them. It also uses a segregated mandate with TwentyFour Asset Management to get exposure to the European asset backed securities and Ashmore Emerging Market Debt.
Long-term equity
Becket argues that equities have a major role to play in cautious portfolios, despite them being one of the riskiest asset classes. Psigma’s cautious portfolios can have a maximum of 30 per cent in this asset class but are currently at 24 per cent.
The CIO recommends taking a blend of many geographies and sectors to avoid being overly exposed to any one and to capitalise on long-term growth, as well as including some defensive equity income that is the more usual preference for the cautious investor.
“Holding equities could well be the right approach over the long term, if you can tolerate the volatility. A major risk that cautious investors need to assess is their current asset allocation mix, not least given our view that if there is value in equity markets then it is mostly in the disliked cyclical and recovery areas of the markets, where typical cautious funds would not dare to venture.”
Emerging market growth
Psigma also takes exposure to emerging market equities, even though this is one of the areas automatically assumed to be high-risk. However, Becket views the US market as being more dangerous than the emerging world at the moment, given its higher valuations.
“As soon as one hears the term ‘emerging markets’ the immediate assumption is that they are always riskier than developed world equities,” he said. “We view this as nonsense; an investor’s real risk is in valuations – if you buy something that is expensive then you have no safety buffer if markets turn down.”
Funds which Becket thinks that meet cautious investors’ growth aims are those with a high-quality bias, like Mirabaud Global Emerging Markets and BlackRock Asian Growth Leaders.
Performance of funds vs MSCI World over 1yr
Source: FE Analytics
Commercial property
Despite commonly being seen as a defensive asset that offer returns uncorrelated from stocks and bonds, Psigma does not hold any commercial property funds in its cautious portfolio.
Commercial property has been one of the most popular asset classes with investors over recent years. Some of the larger bricks and mortar funds have doubled in size over the past year, with competition being funds for property being one of the reasons why London prime yields are now lower than they were in the bubble of 2007.
“This makes us very concerned, particularly as investors are scantily compensated for future risks, and we are also nervy about the mix of illiquid assets and investors’ short-term desires in UK commercial property bricks and mortar funds,” Becket said.
“These funds might perform satisfactorily in future years, but certainly much of the return has already passed and it is debatable whether the mix of very low income returns and illiquid assets can truly ensure that such funds can be considered cautious.”
Inflation protection
The wealth manager also incorporates inflation protection into their cautious portfolio, as well as the strategies outlined above that aim for medium-term growth. However, it believes that the traditional way of achieving this – index-linked gilts – are risky due to their linkage with conventional gilts.
“Reassuringly some better opportunities can be found overseas, such as US TIPS, where inflation ‘break-even rates’ afford some protection to investors. Our holding in the Fidelity Global Inflation Linked fund is efficiently exploiting this opportunity on our behalf,” Becket added.
The firm is also making use of commodities to protect against inflation, even though this is not typically an asset associated with cautious strategies. But the CIO argues that the scarcity of inflation hedges elsewhere in markets means natural resources are needed if there is “any chance” of offering inflation protection over the coming decade.
“We are currently comforted by the fact that commodities are considered the devil of the investment world and can be considered to be cheap from a long-term perspective.”
Defence
Becket points out that the defensive element of a cautious portfolio is “vital” in ensuring it will meet the investor’s overall long-term aims and make sure they are not hit by a capital shock in the short term.
However, given his argument that many traditional defensive assets are looking risky at the moment, hedging a portfolio now is “far more challenging” than it has been in the past. If Psigma’s worst fears come true, then government bonds – which would normally be the go-to asset – will be “rendered useless”.
“We have therefore worked hard to source alternative streams of return, from strategies that should deliver positive returns regardless of market direction,” Becket said.
“Key examples are the Aberdeen Short Duration Asian Bond fund, which is a play of high quality Asian bonds and the US dollar. Another key position is the low volatility Legg Mason Global Credit Absolute Return fund, which has a history of eking out positive gains throughout a market cycle.”
Performance of fund vs benchmark since launch
Source: FE Analytics
Becket caveats his argument by saying that investors who believe bond yields will remain “ludicrously low” for some time could get away with holding low-yielding, long-duration bonds with some high-quality equities and commercial property.
This will lead to “uninspiring” returns, in light of both the recent past and long-term history, but this will be “perfectly reasonable” when compared with the available returns on cash.
“However, if you have any doubts about that depressing outcome or feel, as we do, that the chances are that the world will gradually recover, interest rates will rise from the rockiest bottom and inflation will pick up, then we would urge you to act now to change your cautious asset allocation mix,” he added.
