Newton Real Return on the defensive

"Just now we are pretty defensive," says Iain Stewart, manager of Newton Real Return, a member of the IC Top 100 Funds. "The equities we hold are defensive and focused on not particularly cyclical industries such as healthcare, pharmaceuticals, tobacco, utilities and telecoms. We like these companies because of their stability, but equities are valued every day and are volatile, so we try and dampen the volatility with other assets."

Corporate debt exposure is down a lot, accounting for 3 per cent of assets, and exposure to government bonds is 20.5 per cent as at 31 May. "We had high yield bonds but have taken that exposure right down," says Mr Stewart. "We have raised cash from the sale of government bonds and high yield debt, so are pretty cautiously positioned."

Cash and cash equivalents account for 11.4 per cent of assets.

"Government bonds do not look like a great investment and their yields are likely to rise," he continues. "But if interest rates go up it may affect risk assets more and bonds less. I still feel that with a deflationary emphasis mainstream government bonds will be a relatively safe area. But there is more risk as you move away from mainstream government bonds.

"Our view is that markets are driven by central bank liquidity and a lot of the conventional ways markets work has changed. It is encouraging more people to reach for yield and it is not going to end well.

"I don't believe we are in an upward trajectory like during the 1980s and 1990s: at the start of the 1980s interest rates were high and could fall, while profit margins were low and could rise. But now we have low interest rates, margins and valuations are high, and central banks have already spent a lot of money."

These policies also don't drive sustainable growth.

"Valuations are up but expected returns are falling, which means higher risks and lower expected returns," continues Mr Stewart. "Central banks efforts are mostly focused on financial markets so there is a disconnect with what can happen with real economies. An eerie calm has settled on markets, and investors are happy to buy lower quality situations. The last time this happened was in 2006 which led to a really big increase in leverage (debt). Then the financial crisis followed."

There are fewer primary dealers and market makers prepared to take the risk of holding inventory, while products like daily dealt securities such as exchange traded funds (ETFs) can give the impression of boundless liquidity in illiquid or esoteric asset classes, though this may not be the case.

Challenges

Investors seeking to preserve capital face a number of challenges.

"In previous bubble episodes the assets involved might have been in a narrower and more obvious range, for example, technology, peripheral Europe or US housing," says Mr Stewart. "But this time because of the size of the stimulus everything could be involved in being pumped up and over valued. This means diversification will not work.

"We accept that there will be some more volatility and own assets we understand, because the businesses underlying the shares or bonds should still be around following turbulence. For example, we are pretty certain pharmaceutical companies will still be around even though the shares may be shaken a bit."

Mr Stewart has diversified the defensive part of the fund.

"We own government bonds from safe haven areas such as Norway and Australasia," he says. "We have direct hedging on equity markets, for example, futures and options, and because volatility is low we can buy these at a reasonable price."

The fund also has direct gold exposure via exchange traded commodities together with holdings in gold mining shares.

"We try and take a view on currencies," he adds. "The US dollar is an anti-risk currency because it is still a dollar funded world.

"The risk is if we hedge too much then we lose upside. However, previously we have captured a decent amount of upside, and protecting capital is as important to us as getting upside."

Expected returns look low but Mr Stewart and his team will try to be tactical.

"If we see opportunities we will add them, but only if we can buy them at the right price," he says. "Higher quality equities and globally diversified businesses are where we can be most constructive, but everything is a bit over valued."

The fund doesn't have much exposure to financial markets in China and he feels that there is "a bit of a mania for things that relate to the internet, in particular in the US". "There is also lots of froth in credit markets, especially high yield and real estate markets," he says. "But it is pretty broad based so it is hard to see."

He is also avoiding companies geared into the current cycle, for example, in financially related areas or with a lot of debt.

"We are avoiding commercial real estate which we feel is pumped up," he says. "And we don't hold much in developing markets: these are good long-term but policy in the west distorted these, as well as money flowing from developed to developing countries.

"Some emerging markets fundamentals are also not as robust as in the past. Growth is not just intrinsic but a result of low interest rates. There has been much more stimulus in these economies than people realise. Asset prices are too high: emerging equities are better than debt but I want to see less enthusiasm and euphoria, and lower prices."

The fund mostly gets exposure to emerging markets via large multinationals which sell into these countries. Exceptions include:

■ Millicom which develops and operates cellular telephone networks in emerging markets, though is listed in Sweden; and

■ South Africa listed Naspers which offers internet services focused on ecommerce, pay TV and print media.

"Both have more potential for growth than the rest of the portfolio but they are small exposures," he says. "Because the rest of the portfolio is defensive we can have a few higher growth holdings."

Source: Morningstar, *BNY Mellon

Source: Morningstar

Top 10 holdings as at 31 May 2014

Asset allocation