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De-risking your Isa or Sipp

The best ways of shielding your investment portfolios from market turmoil
June 11, 2012

Market jitters sparked by the growing turmoil in the eurozone and fears of a meltdown in the single currency have sparked a massive flight from risk. But traditional 'safe havens' might not be as safe as you think, and you certainly don't want to dismantle an equity portfolio every time the market suffers a bout of volatility. So is there another way to de-risk a portfolio, particularly one held in a tax wrapper, where selling might mean relinquishing valuable tax benefits?

The traditional safe havens during troubled times were quality government bonds and gold. But bond prices have been on an epic bull run and look expensive. Gold has been very volatile lately, while inflation continues to chip away at cash holdings yielding paltry returns.

These investments still have a role to play in a balanced portfolio, but there are other, more innovative ways to de-risk.

Cash is not king

Many investors may be contemplating a move into cash as the quickest and most logical way of de-risking their Sipp and/or Isa portfolio. Within a Sipp, you can move money into deposit accounts with banks or building societies (see our note below on the factors you should consider before doing so). While cash can be held over the long term in your Sipp, within a stocks and shares Isa you can only hold cash temporarily in a cash reserve account, also known as a 'cash park'. The key here is that this must only be a temporary move and you should have the intention to reinvest the money at some point .

Tim Cockerill, head of collectives research at Rowan Dartington, says: "As a way to pull out of the equity market and be ready to re-invest, I think moving some of your Isa into cash is a useful strategy. My understanding is that investors' intention should be to invest the cash into equities, but I don't believe there is an actual limit. In my experience holding cash for a number of months is not an issue, but a time period such as two years would be. Timing is always a consideration and once in cash re-investing when markets are stressed is never that easy."

Besides, the risk of selling after the market has fallen and then re-investing after the market has bounced, the cash held in your Sipp or Isa is unlikely to generate returns that stays abreast of inflation.

"Cash equivalents may actually fall in value as inflation erodes purchasing power - by printing more money to try and boost the economy, the government has eroded its value," says Gemma Godfrey, head of investment strategy at asset manager Brooks Macdonald.

The other possibility is to hold a cash fund - Mr Cockerill recommends Fidelity Cash Fund (not Isa eligible), but again the yield is very low - virtually nothing. However, Mr Cockerill points out that this is not the reason to hold such a fund - the reason is security. See our article on Choosing a Money Market Fund for more on these funds and the factors to assess before you invest into one.

"Money market funds hit the headlines a few years ago for all the wrong reasons as, while investors assumed they were invested in cash, they were in fact invested in other instruments which lost a lot of money. They are under a lot more scrutiny now, though, and this shouldn't put investors off as there are some plain vanilla cash funds available," says Darius McDermott of Chelsea Financial Services.

Lowering risk

If you're looking to lower the risk of your portfolio, it is important to start by defining what you mean by 'safe'.

"If safe equates to no volatility/risk then gold, property and bonds don't fit. However, if a small degree of risk is acceptable then property and bonds do become an option, although selection is critical. Focus on very high quality and in the case of bonds, short-dated ones need to be held. Under normal circumstances these should be very secure and this is still likely to be the case but there is a risk in the event of a serious dislocation in markets and economies that they lose value," says Mr Cockerill.

He continues: "If security is seen as avoiding default then government bonds such as gilts have to be considered. Although yields are at very low levels and there is a risk of capital loss in the short term, in the long term it is very easy to see the return on a gilt to redemption by looking at the gross redemption yield, and from this angle they remain very safe - but it's not a great return."

Eric Parker, investment analyst at Equilibrium Asset Managers, suggests investing in a fund that mainly invests in global short-dated bonds such as the Smith & Williamson Short Dated Corporate Bond Fund. "This could potentially keep your money safe from the heaviest bouts of volatility," he says.

Another way of getting access to short-term government debt is via exchange-traded funds (ETFs) such the as iShares $ Treasury Bond 1-3 years (TIDM: IBTS, data here) or iShares FTSE Gilts 1-5 years (IGLS, data here).

Mr Parker also suggest absolute return funds such as the Standard Life GARS Fund which has the mechanisms to hedge out volatility with the variety of strategies that are placed within the fund.

For investors looking to de-risk but not at the cost of sacrificing a decent return, high-yield bonds may be a good fit. Josh Hughes, sales director for corporate credit specialist fund manager Muzinich & Co, explains: "While high-yield debt may not immediately come to mind when looking at de-risking strategies, the asset class has many attractive attributes that make it suitable for this purpose. One important point to remember is that the high-yield market is predominantly in US companies. While the US is far from immune from the eurozone crisis, it is one step removed and so the impact on US high-yield issuers of a Greek exit or other negative news flow will be less keenly felt than in Europe."

The biggest attraction of high yield in the current market and, in most circumstances, is the coupon. "Getting an 8 per cent (the approximate current average yield) return on your capital every year is extremely valuable to an investor. This is particularly so when compared with government bonds because the flight to so-called safety during the eurozone crisis has seen yields plummet - Germany even issued a two-year bund paying 0 per cent recently," says Mr Hughes.

Another attraction of high yield is its low correlation to other asset classes. From 1993 to March this year, the correlation of US high yield to a 10-year US Treasury bill was minus 0.10 and compared with equities, as represented by the S&P 500, it was 0.6 per cent. "Clearly it pays to be uncorrelated to major asset classes currently, so this is another major attraction for investors seeking to de-risk and diversify their portfolios."

Ece Ugurtas, head of credit investing at Barings, agrees. He says fundamentals in the high-yield market, including the record low default rate, remain sound. "New issuance has been mainly to extend maturities and shore up liquidity. While we do not rule out short-term volatility as investors switch between an optimistic and pessimistic view of the world, we expect the high-yield corporate bond market to continue to offer attractive risk-adjusted returns."

Buy equities

With safe-haven investment at risk from inflation and growth expectation low, many investment managers and advisers are touting equity income as a sensible strategy.

"Investor overreaction can offer buying opportunities, with share price corrections providing attractive, cheaper entry points to high-quality companies. Furthermore, the yield from dividends these companies pay out can provide a valuable income stream," says Ms Godfrey. "With many investors holding back capital, the flow of money back into markets, buying into sell-offs at lower levels, could dampen these downward moves and provide a level of support."

She is advising clients to ensure their Sipp and Isa are invested in funds focused on good-quality companies with strong balance sheets paying an attractive level of dividends.

Tom Stevenson, investment director at Fidelity Worldwide Investment, adds that with the investment backdrop likely to remain tough for a long time to come, people will pay for certainty and that will favour companies that can demonstrate sustainable growth, the ability to access credit, geographic and operational diversity and good management.

"Often these stocks offer a sustainable income and often the yield is higher than corporate and government bonds. Not only does this dividend provide the lion's share of total returns, it also is an indicator of a company's underlying quality. Therefore, equity income funds or blue-chip stocks are good investment strategies for uncertain times," he says.

The US stock market, for example, has not traditionally been famed for its yield compared with the UK; however, it is still home to solid, high-quality companies that pay handsome dividends such as in the utilities and telecoms sectors. With the US economy growing steadily, investors can be comfortable they will enjoy reasonable dividend streams into the future.

But Robert Farago, head of asset allocation at Schroders Private Banking, warns that investors should avoid becoming mesmerised by yield to the exclusion of other sources of return. "Over the last 10 years, high-yielding stocks have done well. But, beware, a strategy fully focused on dividends would have missed out on the biggest asset allocation call of the decade: adding exposure to gold.

"In the US, it would have also missed out on the rise of Apple and other similarly successful tech stocks. Apple is now the world's largest company, but has only initiated a dividend this year. Finally, investors following a quality income strategy risk overpaying for what has become the strategy to follow. The premium being paid for high stability is at record levels looking at data going back to 1990."

Diversification

Advisers agree that diversification is ultimately the best way to de-risk a portfolio. This can be done by spreading your investments across a number different asset classes or simply choosing a multi-asset fund and leaving an expert to worry about diversification for you, although this can be a costly option. Mr McDermott likes multi-asset funds such CF Miton Special Situations and Artemis Strategic Assets funds.

"It is important that investors don't have all their eggs in one basket and they should diversify between assets and geographies. Many investors wouldn't have predicted government bonds to be the top performers last year, nor the demand for save havens this year. Nobody knows what the future holds but a good spread of assets will protect from the unexpected," says Mr Stevenson.

Lump-sum investors could also consider regular saving instead and drip-feed money into the market, benefiting from pound cost averaging. So you buy more units when the prices are low and fewer when prices are high - this cushions you from dips in the stock market because you are buying your units at a variety of prices. Read the article - Drip feed your Isa - for more on this.

Of course, with both a Sipp and a regular Isa investment, you can stop your contributions for a while - although this can be dangerous for another reason: if you leave it too long to start your contribution again, you could lose out and not only need to save more each month to make up for it, but simply not have enough time to save more before you retire.