56 per cent of investors believe that building a cautious portfolio has never been as difficult as it is today, according to poll data from FE Trustnet. 
The increasing difficulty investors have faced over the last year or so in their hunt for ‘safe’ assets has been well-documented, with traditionally low-risk assets such as government bonds increasing in price and lowering their yields as a result of ultra-loose monetary policy.
Their performance actually converged with higher risk equities in August last year amid fears surrounding the Chinese growth slowdown and the oil price collapse, leaving investors more unsure than ever in terms of how to diversify their portfolio.
Meanwhile, there have been fears surrounding the ever-increasing popularity of property as a diversifier and source of income, with many investors believing that the property bubble is on the verge of bursting.
Even for investors with a higher risk tolerance, toppy valuations across equity markets have meant that investors have struggled to find attractively-valued growth opportunities.
“I totally agree that there have been challenges for cautious investors - most of this has been because bonds are very expensive - UK government bonds which have gone up 5 per cent so far this year and they are now very close to the most expensive they’ve ever been,” Psigma’s Rory McPherson said.
“The 30-year bull market continues this year and the worry is that they sell off the same time as equities do, which is what we had in the summer of 2013 when we had the taper tantrum.”
“Now, the US central bank has indicated that we get two rate rises this year, which would get bonds selling off simultaneously with equities.”
Last year, Psigma overhauled its cautious portfolio to maintain low risk levels amid today’s market distortion and the individual challenges facing each asset class. For instance, the firm significantly reduced its exposure to typical cautious hunting grounds that could be hit by impending rate hikes.
“In a typical cautious portfolio you would have lots of UK government bonds and they would be very sensitive to interest rate movements. To put that in a return context, if you had interest rates move up by 1 per cent you would take a negative 10 per cent hit on your cautious portfolio so we’ve massively guarded against that and we have very low exposure to interest rates,” McPherson explained.
To gain exposure to fixed income while also minimising rate rise impacts, Psigma has increased the exposure of its cautious portfolio to credit assets that are being bought by the ECB through quantitative easing.
Thomas McMahon, fund analyst at FE, says the FE Research team likes M&G Corporate Bond for investment grade exposure, which has been run by FE Alpha Manager Richard Woolnough for more than a decade.
“Woolnough is bullish on investment grade bonds, although he prefers the US to Europe. The manager believes that there is value in current spreads, particularly BBBs,” he said.
Currently, the £4.5bn fund’s largest regional exposure is the UK at 56.4 per cent followed by North America at 21.58 per cent.
However, 17.55 per cent of the fund is in in European fixed income – this includes holdings in the European Investment Bank, Electricite de France and Madrid-based telecom firm Telefonica Emisiones.
Over five years, the fund has provided a total return of 35.38 per cent compared to its sector average’s return of 30.94 per cent. It also has a top-quartile annualised volatility, risk-adjusted return as measured by its Sharpe ratio and maximum drawdown, which measures potential money lost if bought and sold at the worst times, over the same time frame.
Performance of fund vs sector over 5yrs
Source: FE Analytics
M&G Corporate Bond has a clean ongoing charges figure (OCF) of 0.66 per cent and yields 3.6 per cent.
Another way that McPherson says Psigma is positioning its cautious portfolio is by holding a number of particularly bearish fund managers, who will make different judgment calls from their bullish competitors and therefore add greater diversification to the portfolio.
“Ian Spreadbury’s bearishness has been very fruitful for our portfolios over recent year,” McMahon said.
“He kept the duration on Fidelity Moneybuilder Income and Fidelity Strategic Bond reasonably high when most managers were slashing it in expectation of a correction in bonds. Spreadbury’s analysis of the economy meant he thought such a sharp rotation to be unlikely, and he has been proven right.”
Fidelity Moneybuilder Income predominantly aims for an attractive level of income through holding either sterling-denominated fixed income assets or global assets which have been hedged back to sterling.
The £3.4bn fund has 381 holdings spanning across the UK, North America, Europe and Australia – while more than 40 per cent of these are BBB-rated, it also holds 21.35 per cent in A, 13.3 per cent in AA and 15.7 per cent in AAA-rated bonds.
The fund, which has outperformed its sector average by 197 basis points over the last five years with a return of 32.91 per cent, has a clean OCF of 0.56 per cent and yields 3.7 per cent.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
If investors would like to add further cautious holdings to their portfolio they should buy into funds that are benchmarked against cash, according to McPherson.
“The key thing for us about cautious investing is the investor doesn’t want to lose their money - they see losing money as getting a worse return than what they would get in a bank,” he explained.
“We don’t want our managers to hide behind bond benchmarks so being benchmarked to cash is a good thing for us and quite a lot of our allocation is in managers who have this cash benchmark.”
McMahon says that the FE Research team uses absolute return fund Insight Absolute Insight within the cash allocation of their portfolios. While he says it has not had a good year, he points out that it has proven to be quite dependable over the long-run.
Insight Absolute Insight is run by FE Alpha Manager Sonja Uys and invests in other mutual funds, all of which are owned by Insight.
While it underperformed its index last year and year-to-date, it has outperformed cash by almost three times over the last five years with a total return of 7.88 per cent.
Performance of fund vs benchmark over 5yrs
Source: FE Analytics
Insight Absolute Insight has a clean OCF of 0.98 per cent.
To diversify its cautious portfolio further, Psigma holds small weightings in gold and resources as a hedge against inflation.
“These small holdings can actually offset the portfolio quite well,” McPherson continued. “To give you an idea of the contribution we’ve had from them, we’ve had 1 per cent positive contribution from our 2.5 per cent holding in gold stocks this year - that’s a big punch from a small holding.”
In terms of gold, the FE Research team rates FE Alpha Manager duo David Ballance and Steve Russell’s CF Ruffer Total Return fund very highly.
McMahon says the fund is conservatively-run and is positioned for an uptick in inflation – as such, it currently has a 7 per cent allocation to gold and gold equities.
The £2.9bn fund aims to achieve low volatility and positive returns through a wide range of asset classes including bonds, currencies, equities and alternatives.
Over five years, it has achieved a top-quartile annualised volatility and downside risk, as well as an above-average alpha versus its peers in the IA Mixed Investment 20%-60% Shares sector.
It has, however, provided a total return of 19.87 per cent over the same time frame which is an underperformance of 2.76 percentage points compared to its peer group composite. That said, it has more than doubled its sector average since the managers took to its helm in 2006 as shown in the below graph.
Performance of fund vs sector under Ballance and Russell
Source: FE Analytics
CF Ruffer Total Return has a clean OCF of 1.23 per cent.
In terms of resources exposure, the FE Research team rates the management team behind BlackRock Natural Resources Growth & Income.
“The fund invests in mining, energy and agricultural commodities which has helped it to take the edge off some of the volatility, as does the focus on yield,” McMahon explained.
“It might not be the best bet for those who want to speculate on a sharp rebound in oil and China-dependent commodities, however.”
While the fund has an FE Risk Score of 132, which estimates that it’s 32 per cent higher-risk than the FTSE 100, a small weighting can add diversification and minimise the overall downside risk of investors’ portfolios during energy bull markets.
The £32m fund is managed by Skye MacPherson, Alastair Bishop and FE Alpha Manager Tom Holl. While it has delivered a negative total return over one and three years due to plummeting commodity prices, the fund has significantly outperformed the FTSE All Share index over the last six months, outperforming it by more than three times over the last three months due to the recovering oil price.
Performance of fund vs FTSE All Share index over 3months
Source: FE Analytics
BlackRock Natural Resources Growth & Income has a clean OCF of 1.8 per cent and yields 3.76 per cent.
One final area that Psigma believes is a good option for building a cautious portfolio is emerging market debt, which may come as a surprise to many investors given the recent volatility in the market area.
“Emerging market debt has a decent yield. The yields of UK and US sovereign bonds is 1.35 and 1.7 per cent respectively which is really very low and they’re high-risk if rates move out,” McPherson explained.
“In emerging markets you don’t have so much interest rate risk, which is good news if rates rise. The yield they offer is about 5 per cent so you’re getting that volatility cushion which gets paid out pretty regularly.”
The FE Research team likes M&G Emerging Markets Bond, which has been run by FE Alpha Manager Claudia Calich since 2013.
“The manager has done a very good job of managing currency in particular in a terrible period for the asset class which has helped her deliver excellent returns relative to peers,” McMahon said.
Over her tenure, Calich’s five crown-rated fund has provided a total return of 22.57 per cent, more than doubling her average peer in the IA Global Bond sector.
Performance of fund vs sector under Calich
Source: FE Analytics
M&G Emerging Markets Bond has a clean OCF of 0.94 per cent and yields 4.92 per cent.
