The funds that provide protection in the sell-off

Although recent adjustments to your portfolio might have included rebalancing, and even adding funds and shares at prices below their previous highs, you also need to understand which diversifiers may merit a place in your portfolio. Not all assets normally associated with diversification have fared well in the crisis, and not all outperformers should be viewed as defensive holdings. But perhaps one good thing about the recent sell-off is that it has made clear which funds have the ability to protect investor cash.

Strong defenders

Equity markets were punished over the first three months of this year, with, for example, the FTSE All-Share and MSCI World indices falling by 25.1 and 15.7 per cent, respectively. But some classic safe havens have held up well.

Developed country government bonds have maintained their role as a defensive asset in times of equity market stress. The majority of around 300 open-ended funds in Investment Association (IA) sectors that made a positive return during the first quarter of this year were either dedicated government bond funds or fixed income funds with a heavy focus on this area. For the time being, any government bond exposure could prove useful. A simple way to get exposure to them could be an exchange traded fund (ETF) such as iShares Core UK Gilts UCITS ETF (IGLT). It offers diversified exposure to UK government bonds for a low ongoing charge of 0.07 per cent.

A drawback of using a passive bond fund over the longer term is that fixed income indices tend to have very high levels of duration – exposure to interest rate changes. iShares Core UK Gilts UCITS ETF, for example, had an effective duration of 12.8 years at the end of March. Funds with high levels of duration have benefited from low and falling interest rates, and many top-performing active gilt funds have a bias towards long duration debt. But such characteristics could be detrimental to their returns if at some point central banks raise interest rates.

Active funds have the option of changing their duration, so if you want to invest in one of these Allianz Gilt Yield (GB0031383390) looks like a good option. The fund's manager, Mike Riddell, pays close attention to macroeconomic and political factors in the UK, and considers how they could affect the debt market. He also focuses on factors such as inflation and duration as sources of outperformance.

If you want to invest in a fund with a wider investment remit, strategic bond funds with a preference for defensive holdings that provide exposure to government debt might be a better option. Examples include Allianz Strategic Bond (GB00B06T9362), which we recently tipped and is run by the same team as Allianz Gilt Yield. Allianz Strategic Bond's managers aim for it to have a low correlation with equities so that it “behaves like a true bond fund and plays the role in diversifying investors’ portfolios that bonds should”. Mr Riddell also says that the fund differs from its peers because its performance is driven by exposure to global rather than UK influences. 

Although this fund can invest in various types of bonds, Mr Riddell has focused it on government debt, in which it had more than 90 per cent of its assets at the end of February. But this could change: Jack Norris, a fixed-income manager at Allianz Global Investors, recently noted that investment-grade corporate bonds had become "more attractively valued than they have been in a long time".

So far, corporate bonds and the funds that invest in them have not fared as well as government bonds. Just a few funds with a focus on the highest-quality corporate debt, such as ASI AAA Bond (GB0006584543), made a positive return during the first quarter. However, a fixed-income fund that has highly defensive positioning, but less focus on government debt, is Jupiter Strategic Bond (GB00BN8T5596). Its manager, Ariel Bezalel, has taken a notably cautious position in recent years, with high allocations to government and high-quality corporate bonds as he expected an economic downturn. Following the sell-off, he has been buying defensive corporate bonds at lower valuations, but remains “highly cautious” due to extreme levels of global debt, a US dollar shortage and the large number of emerging market economies that rely on Chinese growth.

Defensive multi-asset funds

As we discussed in the Big Theme of 11 October 2019 – Make the most of the many uses of multi-asset – these funds can prove to be a defensive addition to your portfolio. Ruffer Total Return (GB00B58BQH88) and Ruffer Investment Company (RICA), for example, take an extremely defensive stance, and have held up relatively well. 

Ruffer Total Return seeks to deliver low-volatility positive returns by investing in various different types of assets and has a “fundamental philosophy of capital preservation”. The fund invested heavily in defensive assets long before markets crashed, and at the end of March held government bonds and gold, while using derivatives to hedge against market falls. But equities accounted for about a fifth of its assets, giving it the ability to deliver some level of longer-term growth and take advantage of volatile market conditions.

Troy Trojan (GB00BZ6CNS31) aims to outperform UK retail price index (RPI) inflation over five to seven years. Its managers take a similar approach to Ruffer Total Return, investing some money in equities, but offsetting risk with defensive allocations. The fund had 42 per cent of its assets in equities at the end of March, with 42 per cent in bonds and 12 per cent in gold-related investments. Its managers have upped its equity exposure from 33 per cent at the start of the year, with a focus on businesses that have healthy balance sheets and good margin structures. They added to positions including Alphabet (US:GOOGL), Berkshire Hathaway (US:BRK.A) and Visa (US:VISA) in March.

Personal Assets Trust (PNL), an investment trust run by the same team, has also proved relatively resilient despite the enhanced volatility of share prices. It made a share price total return of -2.5 per cent over the first quarter – a much smaller fall than broad equity markets.

Where fund choices matters

Gold, another classic safe haven, has recently performed well as investors flee to it for safety and funds that track its price have made good returns. For example, iShares Physical Gold ETC (SGLN), which owns gold so follows its spot price, made gains of more than 12 per cent over the first quarter. This and similar physical gold exchange traded commodities (ETCs) should generally continue to do well at moments of market panic because they have holdings in the asset.

But active gold funds have suffered large losses because they invest in the shares of gold mining companies – rather than holding the metal itself. And gold miners have not been immune to market swings and concerns about the effects of the coronavirus lockdown. Although gold mining shares and the funds that buy them have recently surged amid a pick-up in market sentiment, they could be punished again if the mood turns sour. So they should not be viewed as defensive holdings in the current environment.

It is also worth noting that the gold price can temporarily tumble in moments of extreme volatility, as it did in late February. This has been attributed to investors seeking easy sources of liquidity in a sell-off, and also affected Treasuries (US government bonds) earlier this year. But it should hopefully prove to be short-lived.

Where to tread carefully

Some asset classes with diversifying characteristics have not held up so well. For example, commercial property has struggled due to the economic impact of Covid-19, and with many countries in lockdown much of the property market has shut down for now. This has led many open-ended direct property funds to suspend trading because of difficulties establishing accurate valuations. Closed-ended property funds also face economic challenges. For example, some tenants are struggling to pay rents, resulting in Empiric Student Property (ESP) suspending dividend payments.

Some absolute-return funds have delivered an impressive performance during the sell-off. Argonaut Absolute Return (GB00B7FT1K78), for example, takes long and short equity positions and made a 22.6 per cent return over the first three months of this year. Much of this came from shorting stocks – betting on their price falling – that have run into trouble amid the crisis. In March alone the fund made huge gains from shorting UK property company Hammerson (HMSO), Cineworld (CINE), aircraft leasing company AerCap (US:AER) and Finablr (FIN), a forex and payments provider whose shares were recently suspended amid concerns about embezzlement.

But Argonaut Absolute Return's performance can also be extremely volatile, so it should not be regarded as a steady, defensive fund. Its annual returns highlight this, for example, it returned 12.8 per cent in 2019 but lost 11.7 per cent in 2018. Long/short approaches often amplify a fund's returns depending on whether its manager's positions play out so can be volatile.

This is also the case with many other absolute return funds, again because their success often relies on a manager making the rights calls, meaning that their performance is often inconsistent. Analysis by broker AJ Bell recently found that of 38 absolute return funds with a 10-year track record, just one had beaten cash returns in each of the past 10 years.

How defensive funds held up