Constructing a cautious portfolio has always been very tough, as has defining exactly what one is. Today, however, most professional investors are clear that it is more difficult than usual to build a portfolio centred on downside protection and diversification set up for the cautious minded. 
Indeed, more than half of investors now believe that today’s market is the most difficult environment in which to build a cautious and diversified portfolio that they have ever known, according to a poll (pictured right) of nearly 2000 FE Trustnet readers.
With this in mind, and in keeping with today’s theme, in this article we hear from fund managers known for their cautious credentials on how they are currently approaching cautious portfolio construction.
Troy’s Sebastian Lyon – ‘Hold some cash, buy defensive equity and avoid corporate bonds’
First up the manager of the £2.7bn Troy Trojan fund Sebastian Lyon (pictured) says the current state of market makes the task of constructing a cautious portfolio “very difficult.” 
Historically, he says, a negative correlation between bond and equities had allowed investors to generate a ‘barbell strategy’ by holding across the two asset classes.
“Equities could be expected to perform well in a risk-on environment with bonds acting as an offset when equity markets were falling. Now however, many government bonds are on historically low yields whilst equities are equally very expensive. 2015 saw the S&P 500 index trade on a higher cyclically adjusted PE ratio than it has 95 per cent of the time since 1881,” Lyon said.
“For this reason we believe that the asset allocation of a portfolio today must include cash. Whilst cash will not offset the falls in equity and bond values, it will provide the optionality to invest when asset prices are at more attractive levels.”
“In terms of asset classes that we avoid, we will tend to steer clear of equities at the more cyclical and capital intensive end of the spectrum. Capital intensive industries tend not to create value for shareholders over the long run whilst cyclical stocks will tend to perform more poorly in a market downturn, an impediment to our objective of capital preservation.”
Lyon instead looks to own companies that he says possess ‘defensive characteristics’ that should allow them to compound decent earnings growth regardless of economic conditions as well as avoiding debt at the corporate level.
“Whilst we are invested in index-linked government debt, we will tend to avoid investment in corporate debt. Corporate debt levels have risen considerably since the financial crisis, incentivised by lower borrowing costs (S&P ex-financial net debt to EBITDA levels are at decade-highs).”
“The liquidity of such debt is however constrained as stricter capital requirements on banks preclude the sell-side from holding inventories to the same extent that they did in the past. This intensifies the risk of a liquidity squeeze in corporate credit.”
Coram’s James Sullivan – ‘Go short duration for bonds, buy global value for equity’
Next, Coram’s Asset Management’s James Sullivan says all areas of fixed income – apart from bonds with very low sensitivity to interest rates least – are unattractive.
“Building a portfolio is a little like writing a book – you need a start, middle and end – so with that in mind investment themes need to be spread across various investment horizons rather than entirely focussed on ‘long term’ returns.”
“Short duration high(er) yield remains relatively attractive with rates largely remaining supressed and even negative. The short duration element of the trade offers additional comfort of a natural liquidity event in the near future whilst being sheltered from a potential steepening of the yield curve, whilst the yield offers an inflation beating return.”
“Medium term plays would include sustainable well covered equity dividend streams where you can be comfortable of the longevity – an optional twist on that trade would be to pursue a covered call strategy to enhance the yield at the expense of potential capital growth.”
“Throw into the mix a modest allocation to longer term growth opportunities where P/E and P/B valuations are close to all times lows, such as parts of the Asian and South American equity market, and before you know it, you have a well-diversified, blended lower risk portfolio covering all bases.”
He adds that some reserve currencies such as the US dollar as well as gold bullion add enhanced protection in the event of a pickup in volatility and subsequent equity weakness.
“Areas to avoid would include parts of the market overly reliant on balance sheet wizardry, or buybacks, to support earnings. This strategy creates earnings artificially, and is unlikely to be sustainable, particularly in the US market as the cost of US debt likely to rise gradually wit Federal Reserve adjustment.”
Hawksmoor’s Daniel Lockyer - ‘Go beyond the obvious for diversification’
The co-manager of the Hawksmoor Vanbrugh and Hawksmoor Distribution funds also says it isn’t easy building a cautious portfolio at the moment but by looking beyond traditional asset classes, investors can find diversification.
“Examples include a decent (5 per cent) allocation to gold equities for insurance against central bank incompetence. It cannot be debased or yield less than nothing apart from storage costs; short duration corporate bond funds instead of gilts which guarantee pitiful returns at best and large capital losses at worst; a mix of absolute return funds –which offer negative zero or low correlation to equities/risk assets.”
“Also, alternative asset classes that should perform according to their own fundamentals rather than linked to equity or bond market movements such as certain property e.g. student accommodation or German residential property, infrastructure, micro-caps, private equity, convertible bonds; ensuring the currency exposure is appropriate and diversified and try to understand how different currencies react in risk on/risk off conditions; and having some cash (currently c.7 per cent) as optionality for when valuations are attractive again.”
“Ultimately it is about assessing the risk/reward in all investments and trying to get a margin of safety when investing (how much can be lost if you are wrong vs upside if you are right), and building in true diversification beyond simply equities and bonds.”
JP Morgan Asset Management’s Talib Sheikh - ‘Buy non-cyclicals but evaluate correlation risks’
The manager of the JPM Cautious Managed fund, which has been the best performer in the IA UK Mixed Investment 0-35% Shares sector over the past year again says diversification in portfolios “has become much, much harder…but has been incredibly important” over the past year.
Performance of fund, sector and index over 1yr
Source: FE Analytics
“You saw that in August last year when you lost money in fixed income and you lost money in equities. You are now having to work harder to get diversification into your portfolios. On a forward looking basis returns are likely to be lower given where valuations are. The risk that you take for driving those returns is likely to be higher and the correlations are going to be much more unstable.”
“We deal with by taking asset allocation to the more granular level. Making sure that you totally avoid sectors and parts of the market where there are not interesting opportunities. Calibrating your portfolio to make sure you don’t have any 'dead' risk whatsoever.”
“We haven't held anything such as material stocks in our portfolio, oil stocks or value and yield stories that are out there and simply haven’t worked. Instead we are trying to think about what sectors will prosper in this environment. Healthcare stocks for example have been a really nice trade because they are companies that have non-cyclical growth and reasonably attractive dividend yields.”
Sheikh also likes European telecoms stocks as he says they are used to operating in a deflationary environment and is avoiding the stocks such as Unilever which have been increasingly seen as ‘bond proxies’ owing to their increasing correlation to bonds.
“A default positon has been to buy the bond proxies but that hasn’t really worked. You need companies that have robust business models and are able to operate in a deflationary, or dis-inflationary environment.”
“In a cautious portfolio you can’t be 100 per cent in equities. So you have to think about what type of fixed income assets do you want to hold? Are they giving you some yield and have some semblance of value. People have been talking about the death of fixed income, that hasn’t worked so far.”
“You need to also examine the correlation risk, in many ways that is one of the most important things.”
Premier’s Simon Evan-Cook – ‘Buy non-expensive quality equity, avoid gold’
The co-manager of a host of multi-asset portfolios including the £900m Premier Multi-Asset Distribution fund thinks equities offer the best long term value as they have not historically lost money over the very long term whereas more traditional safe assets such as cash and government bonds have done so.
“The two most common fragilities are assets that are expensive, and assets that are poor quality. We try our hardest to avoid both. And if you hold an asset that is both poor quality and expensive, you should sell it today.”
“Ideally then, we should be holding assets that are high quality and cheap. But those are thin on the ground at the best of times, and these are not the best of times. That leaves assets that are reasonable quality and good value, or high quality and reasonable value. These are not perfect, but considerably better than the alternative.”
“Otherwise, our conservative growth funds have a broad selection of assets that are good quality and not expensive. That does not include gold, as it’s extremely hard to gauge whether it’s highly expensive or a bargain. And it doesn’t include gilts, whose valuation makes them vulnerable to an unexpected pick-up in inflation.”
Liontrust’s John Husselbee - ‘Buy enhanced equity income and strategic bond funds’
John Husselbee (pictured), head of multi-asset at Liontrust says while cash, bonds and income yielding equities have traditionally been the building blocks of a cautious portfolio this is no longer the case. 
“UK base rates are anchored at historic lows and ten year gilt yields remain lower than the Bank of England inflation target. Negative real returns are not attractive for long term investors. The future lies partly in taking on a little equity risk and finding alternative sources of return, both income and capital growth.”
“Non-traditional asset classes and making use of liquid alternative strategies have become more readily available to retail investors. We have invested in strategic bond funds and equity enhanced income strategies to complement our traditional approach."
