Cautious funds for your Isa

While it has been more than five years since the start of the credit crisis, with some, including Schroders' head of equities Richard Buxton, claiming we are in the "foothills of a new bull market", and analysts at Citigroup predicting that the FTSE 100 will reach 7000 by the end of 2013, investors who have suffered a series of blows over the years may remain skeptical.

Periods of extreme volatility have tested their nerve. However, Danny Cox, from wealth manager Hargreaves Lansdown, comments: "The financial crisis has altered people's perception of risk - nobody thought a series of high street banks could fail.

"Investors might be nervous, but they should be mindful of investing in funds that are too cautious, as they are likely to underperform during a strong bull market and could look rather pedestrian against more aggressive funds."

Even so, the push to steer away from risk has led to the launch of a range of 'cautious managed funds' in recent years as investors tackled the economic storm. These appeal not only to risk-averse investors, but also those approaching retirement who value capital preservation above capital growth.

However, following concerns that the Investment Management Association's (IMA) Cautious Managed funds sector's name misled investors, the sector was renamed in 2011. All funds previously listed in the Cautious or Balanced fund sectors can now be found in the Mixed Investment sector, and divided up according to their equity content.

"Most cautious managed funds simply invest in a combination of equity and fixed interest and not much else," warns Brian Dennehy of FundExpert.co.uk. "Investors purchasing these funds based on a cautious label are being lulled into a false sense of security - particularly if they consider equities risky and bonds expensive."

He stresses that it is vital to look under the bonnet to see what exactly is in these products as some have a large chunk of holdings in shares subject to high levels of volatility. For example, the Kames Ethical Cautious Managed Fund (GB00B1N9DX45) has over 50 per cent in equities.

"Also, the IMA's sector label emphasises a fund's equity exposure, yet it tells you nothing of risks in non-equity asset classes," says Mr Dennehy. "Investors need to look out for funds with significant holdings in highly correlated assets, such as high-yield bonds.

"In a post-Lehman world, assets have become increasingly correlated as central bank interventions drive markets - this means that diversification becomes increasingly important, but more difficult."

Cautious funds can also come with high charges, say experts, with many being "fund of funds". This means an additional layer of fees, with some total expense ratios (TERs) over 2 per cent.

Yet over the past few years, for investors driven down the safe-haven route, it is bond and gilt markets that have shown stellar performance.

Patrick Connolly, certified financial planner at AWD Chase De Vere, says: "The performance of fixed-interest investments has exceeded realistic expectations, with top-performing investment sectors including UK index-linked gilts, and sterling corporate bonds - investors have sought safety at all costs."

He adds: "Over two years, UK index-linked gilt funds have risen by an average of 25 per cent and UK gilt funds by 19 per cent."

However, this has resulted in these asset classes being considerably more expensive, he warns, with fears they have been over-bought and are due a correction. "In the current environment, with investors wanting safety, broadly the riskier an asset is perceived to be the cheaper it is today."

Charles MacKinnon, chief investment officer of Thurleigh Investment Managers, adds: "The dilemma is that there are no truly safe havens left anymore; government bonds are yielding less than inflation, which means that they are not safe except for the shortest period of time, and banks are known to be dancing on the edge of bankruptcy, held afloat only with massive injections of government cash."

So which funds can investors pick to make portfolios less susceptible to disasters?

Open-ended funds

There is a range of funds for investors shying away from taking too much risk with their capital. These include funds that invest in large blue chip stocks with strong balance sheets and which pay decent dividends, boosting returns in a volatile environment.

But experts stress that investors need to take some risk to generate returns over the long term. Gavin Haynes, investment director at Whitechurch Securities, comments: "Equities remain clearly the most attractively valued asset class, and there are opportunities across the globe for both income and growth investors who are prepared to take a long-term perspective."

He favours funds within the IMA Absolute Return sector for the cautious investor. While some of these funds, aimed at delivering a positive return on a 12-month basis, have been subject to criticism for not sticking to their promises, there remain some solid, stable options that appeal during turbulent times.

Mr Haynes says: "While these funds don't guarantee a positive return, many will be less volatile than market-based funds, and can potentially grind out returns irrespective of the investment environment."

For example, Standard Life Global Absolute Return Strategies (Gars) (GB00B28S0093) and Newton Real Return (GB0001642635) have delivered decent returns with low volatility across different economic backdrops. For example, the Newton fund has delivered 4.1 per cent, 11.81 per cent and 35.74 per cent over one, three and five years, respectively.

The Standard Life Gars fund is known for investing across bonds, currencies and equities, as well as esoteric areas such as interest rates.

"The investment areas and financial techniques that the fund uses are truly diverse, both in terms of asset classes and globally, ranging from long-only traditional investing in equities and bonds to making calls on currency, inflation, and mortality, for example," adds Mr Haynes.

"Its diverse nature means the fund offers defensive attributes compared with traditional long-only funds, on a carefully risk-controlled basis."

Meanwhile, the Newton Real Return fund invests in equities and bonds, and also uses other elements such as gold and alternative assets to help benefit from a falling market.

"This is a multi-asset fund whose manager, Iain Stewart, focuses solely on producing a positive absolute return," says Mr Haynes. The fund is targeted to outperform cash by 4 per cent on a rolling, three-year basis.

However, owing to the complex nature of these funds, it is important to understand where they invest and what strategies will be employed before ploughing your capital into them.

Mr Connolly recommends Invesco Perpetual Distribution Fund (GB0033947226), returning 19.19 per cent, 31.04 per cent and 35.74 per cent over one, three and five years, respectively. "This has a winning combination with highly regarded manager Neil Woodford managing equities, and Paul Read and Paul Causer managing fixed interest, with an attractive yield of 5.35 per cent," he says.

 He also likes Threadneedle Defensive Equity & Bond Fund (GB0032009937), with a focus on UK and overseas bonds, and some UK equity exposure. "Risks are incredibly well diversified with the underlying funds holding over 1,000 different investments," says Mr Connolly.

Mr Cox recommends the Troy Trojan Fund (GB00B01BP952). "Manager Sebastian Lyon structures the portfolio by looking at the big picture to form his asset allocation, and then focuses on large-cap stocks with strong balance sheets," he says.

Alternatively, blending a number of equity and bond funds with different investment strategies for a diversified portfolio is an option to smooth returns. For example, Mr Dennehy says investors could opt for Invesco Perpetual Income (GB0033053827) alongside M&G Corporate Bond Fund (GB0031285678).

Mr Connolly says: "Those prepared to accept some investment risk should hold a mix of different assets including equities, fixed interest and property, and stick with them for the longer term, rebalancing regularly and ignoring short-term sentiment and market noise."

Cautious funds

Source: Morningstar, performance data as at 6 February 2013 and *7 February 2013

Investment Trusts

While investment trusts are listed vehicles and susceptible to market swings, there are those that focus on preserving capital, and the fees are typically less than open-ended funds.

The Ruffer Investment Company (RICA), for example, has an appealing record of capital preservation for cautious investors. "It follows an absolute return approach, investing across different asset classes and global markets," says Mr Haynes.

The fund managers have an excellent record of protecting investors wealth during tough times as well as exploiting out-of-favour recovery opportunities. Mr Haynes adds: "This trust makes a good, core defensive holding."

Personal Assets Trust (PNL) is another multi-asset investment trust that operates with a defensive bias, managed by Sebastian Lyon at Troy Asset Management.

The trust has a proven track record in sheltering investors from economic storms.

For example, in 2008 its share price fell 3.2 per cent. This compares with falls of more than 30 per cent for the average global growth investment trust and the FTSE All-Share, and nearly 16 per cent for the average open-ended Cautious Managed fund.

Mr Haynes says: "Mr Lyon employs a very conservative investment approach, where capital preservation during difficult times is at the forefront of the trust's objective. He places little to no regard on benchmarks, and it is wealth creation that is the key philosophy - no doubt borne of the fact that this trust is looking after family money."

Cautious investment trusts

Source: Morningstar as at 6 February 2013. Shows share price total return.

Exchange traded funds

The use of exchange-traded funds provides a low-cost means of tracking areas of equity markets and other asset classes. While not typically aimed at cautious investors, there are some options for the risk averse.

One is to look at an ETF that tracks the gilt market, such as the iShares FTSE UK All Stocks Gilt (IGLT) fund, says Adam Laird, passive investment manager at Hargreaves Lansdown.

This tracks the FTSE Actuaries UK Gilts All Stocks TR Index and is priced at a total expense ratio of 0.2 per cent.

The charging structure for ETFs is basic, as they do not levy front-end charges, early redemption penalties or exit charges, and service charges are often below 0.5 per cent a year.

Most experts have no concerns about the safety of ETFs, except for the underlying asset's volatility, provided that they are physically backed, and run by one of the big issuers such as iShares or Deutsche Bank.