Your investments and how to navigate uncertain markets
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The average investor has plenty to worry about in today’s markets. The outcome of the UK’s future relationship with the EU remains unclear, US President Donald Trump’s trade war with China rages on and markets across the world are teetering near record highs.
In the UK, investors face an uncertain future not only from Brexit, but from the possibility of a future Labour government under Jeremy Corbyn. With no shortage of global and domestic issues for markets to contend with, the FTSE 100 has entered correction territory in recent weeks and continues to plumb seven-month lows.
Meanwhile global stock markets are sliding, with many of the best-loved stocks and sectors of the past 10 years experiencing a sudden sell-off. The tech darlings of recent years were in the spotlight this week ahead of earnings announcements.
With such an unpredictable outlook ahead, shock-proofing your investment portfolio has rarely looked as crucial. Here are FT Money’s tips for tackling risk in your portfolio.
“Nobody can consistently predict which asset classes or sectors will perform best. It is therefore important that investors don’t try to be too clever [in their portfolios],” says Patrick Connolly, chartered financial planner at independent financial adviser Chase de Vere.
Having a well-diversified investment portfolio is key, he says, because “having too much money in one area that underperforms can have a significant negative effect on your overall finances.
“You should therefore spread your money across different assets such as equities, fixed interest, commercial property and cash, but make sure this is in the right proportions to meet your objectives and attitude to risk,” he says.
In the past, bonds and equities were less correlated and investors could take shelter in bonds when equity markets fell. But an era of central bank bond-buying and record low interest has meant the two markets now move more frequently in sync.
Assets such as infrastructure and specialist property can be less correlated to other parts of your portfolio and help ensure that the value of all your assets does not go down in tandem.
Darius McDermott, managing director of broker Chelsea Financial Services, says he uses “a bucket of alternative investment trusts” including things such as “care homes, student accommodation and renewable energy”. Examples include student property investment trust GCP Student Living. The trust owns student properties mainly located in London to capitalise on high demand for student property and scarce supply.
Despite Brexit negotiations, there was a 6 per cent rise in UCAS applications from international students in 2018 and a 2 per cent increase in EU applications, suggesting demand persists for London universities and accommodation.
The trust has returned 12.5 per cent to shareholders since its flotation in 2013, during which its returns have been relatively uncorrelated with the FTSE All-Share index.
Infrastructure trusts such as HICL Infrastructure and International Public Partnerships have also delivered strong returns in recent years. However, they have also been rocked by political wrangling over the future of public private finance initiatives and are expensive, many trading on double-digit premiums to their net asset value.
“Alternative asset classes can be considered by investors who are looking for additional diversification in their portfolios,” says Mr Connolly. “However, they need to be aware that this diversification may come at extra cost, such as more volatility, higher charges and less liquidity.”
Picking funds in uncertain times
Diversification does not end at selecting assets: it is also about choosing different styles of fund manager.
“We often see people with 10 funds and they think that’s diversification,” says Ryan Hughes, head of fund selection at online investment broker AJ Bell. “But investors need to be diversified by asset class, equity region and also by style of fund manager.”
Fund managers may have different views on the world and the kind of company likely to perform best; one style or another can come into its own at different points in an economic cycle.
For example, some managers invest in high-growth markets such as technology, where stocks can be more expensive but growth is often impressive. In contrast, so-called “value investors” buy very cheap, unloved stocks that they hope will do well during an economic recovery. Defensively positioned managers might opt for blue-chip companies with steady dividend streams they believe can keep delivering.
During the long bull run of recent years, the best funds to own were those exposed to high-growth technology companies. Over five years, returns in the information technology sector of the S&P 500 index were almost twice those of the main benchmark, at 190 per cent. But those stocks are expensive, leading to bigger potential losses if results disappoint. And with the era of easy money coming to an end and interest rates rising, the pendulum could swing in favour of other cheaper sectors such as financial services stocks, which benefit from rising interest rates.
“A lot of people will have fallen into the trap of holding funds in recent years that are exposed to the same kinds of stocks,” says Mr Hughes. “They probably have a very heavy growth bias and very high exposure to technology companies. But when we get the next wobble it could be exactly those expensive growth companies that struggle.”
Funds such as Fundsmith, which has a high allocation to technology, have done particularly well in recent years, he adds. Fundsmith is among the top five best-performing global equity funds in the Investment Association global equity sector over three years, along with growth-focused fund house Baillie Gifford and the more defensive Lindsell Train.
But value investing has recently shown signs of a comeback. The MSCI World IMI Growth index, a global equity index of growth stocks, performed far better than the MSCI World IMI Value index in 2017. But in the past six months the tables have turned in performance terms.
“Now you want to buy the best-performing manager in the worst-performing sector,” says Haig Bathgate, head of portfolio management at Seven Investment Management. “You always want to sell the sector and style that has performed the best, in this case large-cap growth, and recycle it, in this case into value.
“I have never seen technology outperform every other sector by such a margin at a time other than 1999,” he says. “There are very few periods in history when value stocks have looked cheaper.”
Value funds focused on UK equities include Schroder Recovery Fund, managed by Nick Kirrage and Kevin Murphy. Its returns were more than triple those of the average fund in its sector in 2016 and in the year to date it has delivered a positive return compared with a 6.6 per cent fall in the FTSE All-Share index. The fund is more heavily invested in financial stocks than its peers. These stocks earn more from their customers when interest rates rise.
Mr McDermott says Jupiter Special Situations is another fund for UK value seekers, while Mr Hughes points to US value-tilted fund Dodge & Cox Worldwide US Stock.
Analysts say now could also be a good time for those invested in the US to shift away from passive funds towards active management, because of the importance now attached by the market to highly valued tech companies such as Amazon. The tech sector now makes up around a fifth of the S&P 500 index, meaning any fall in those shares will give a big jolt to the index as a whole.
They suggest investors with low risk tolerances consider diversifying into funds including absolute return funds and other multi-asset funds — so-called “defensive funds” designed to preserve investors’ capital rather than beat the markets. Such funds are not cheap, however, and can drag on returns when markets rise.
Options include Janus Henderson Absolute UK Return, a fund that takes long and short positions in the market to hedge its exposure to equity markets and make money regardless of which way it moves.
“Diversification feels to me like the most important thing because I just don’t know what’s going to happen tomorrow. I don’t want to just have one type of fund manager in my portfolio,” says Mr McDermott.
Bonds and Brexit
Rising interest rates and inflation upset bond markets and both those factors are in play around the world. The US has already raised rates three times in 2018 and is on track for another rate rise this year.
Bonds with long duration (a measure of interest rate risk) are the worst affected both by rising inflation and interest rate rises, as the fixed coupons they pay are eroded. In October, the price of 10-year US Treasury bonds fell sharply following US economic data pointing to higher inflation, with yields (a measure of bond income that moves inversely to price) rising to their highest level in seven years, above 3.2 per cent.
In the UK, higher inflation and rising rates have resulted in passive funds which track 10-year gilts, including iShares Core UK Gilts ETF, losing about 1 per cent in the year to date.
“Bond markets are not going to be the hiding place they once were,” says Mr Hughes. “Historically we would have diversified portfolios with government bond and corporate bonds. Now the likelihood is you will just lose money less slowly in those places [in a downturn] but are very unlikely to make money.”
Chris Iggo, chief investment officer for fixed income at Axa Investors, adds that bond markets “don’t know what to do with [Brexit]”.
“The outlook is so uncertain that investors are finding it difficult to price in any particular outcome. It is a topic where no one really has a view on the market implications . . . or is able to suggest trade ideas or investment recommendations,” he says.
According to analysts, investors should avoid long-dated bonds and opt for bonds that mature in the nearer term. They pay very little income but are less vulnerable to price swings relating to interest rates and inflation. Another option is to buy strategic bond funds, where fund managers can pick and choose between different kinds of bonds and regions of the world.
Included in that category are TwentyFour Dynamic Bond fund and Royal London Sterling Extra Yield Bond. The former invests in asset-backed-securities as well as more traditional bond areas, meaning it is less correlated with the wider market. The latter has been among the best performing in its sector in the past three years and is heavily invested in bank bonds, among others.
“We like bond funds like Jupiter Strategic Bond and Twenty Four Dynamic Bond fund,” says Mr McDermott, “but most bond managers are extremely bearish on their own asset class and if they don’t like it, be careful.”
How much cash to hold?
Advisers suggest investors should have a safety net of cash to protect against falling stock markets. Having this cash buffer means investors will not be forced to sell when prices are falling, which means they have a better chance of avoiding locking in losses.
“Everybody should have some cash savings to cater for any short-term emergencies or requirements and so avoid the need of taking on expensive debt or encashing investments at the wrong time if money is needed at short notice,” says Mr Connolly.
He suggests it makes sense for most to hold enough cash to cover at least three to six months of personal expenditure. “Many people should hold considerably more than this depending on their circumstances and particularly if they are worried about investment risk,” he says.
However, he adds that for those investors whose income is guaranteed, perhaps through an annuity or defined benefit pension scheme, and this income is enough to cover their basic living costs, they may be able to justify holding a smaller amount in cash.
Even for others with less guaranteed income, there is also the risk that inflation will erode the value of their cash. Rick Eling, investment director at Quilter, a wealth manager, says: “Putting your money in cash can seem appealing as a safe and secure option. However, inflation eats away at your savings.” Over 25 years, assuming annual inflation of 2.5 per cent, a £10,000 cash pot would end up with the purchasing power of £5,310, he says.
“The only meaningful answer to ‘What should I invest in?’ is ‘What do you want to achieve?’,” says Mr Eling. “If you have a known spending goal in the near term, like a new car, then cash might be your best option. There’s no risk that a market fall might force you to buy a cheaper car. But if your goal is to retire in a few decades with enough to fund your life then cash is unlikely to deliver.” Lucy Warwick-Ching
A question of timing
With markets trading near record highs, investors risk losing out if and when the bull run finally comes to a halt. In October the main US index, the S&P 500 index, hit a record high, while the FTSE 100 index hit a fresh peak in May.
But traders believe both markets are on track for a slowdown, according to the price to earnings ratios of both indices. Forward price/earnings ratios express a company’s or index’s price relative to its future earnings. The higher the ratio, the more markets believe a stock or index is likely to grow strongly in the future. A falling price/earnings ratio means the market believes growth is set to slow. High price/earnings ratios can also be a sign that a stock is expensive or over-hyped.
The FTSE 100 is now trading on a forward price/earnings ratio of 11.73, compared with a 10-year average of 12.39. The US main market is trading on a forward price/earnings ratio of 15.72. It has fallen in recent months, but remains ahead of its 10-year average of 14.73.
Attempting to time markets is a fool’s errand, however, say analysts. Instead, drip feeding money into the market on a regular basis takes the emotion out of investing and means the price you pay for stocks and funds will average out over time.
Mr Connolly says: “Investing regular premiums (rather than lump sums) is a sensible way to invest during difficult times and periods of stock market volatility. This approach negates the risk of market timing and means that if investments fall in value then units are simply bought cheaper next time, bringing down the average purchase cost.”
Mr Bathgate says: “We’re definitely nearer the top of the market now than the bottom, but the final phase of these bull markets can be significant. The late 1990s is a case in point,” he adds. “If you had moved into cash too early and not been invested at all you would have missed out on returns.”
Rebalancing your portfolio regularly is also crucial, in order not to drift away from your asset allocation model: that entails recycling money from funds that have done well into those that have done less well. Putting the money back only into the high-performing funds will quickly skew a spread of assets and shift the concentration of risk.
“This is particularly relevant during volatile times as the shape and risk profile of your portfolio can change significantly over a short period,” says Mr Connolly.
“Not only does rebalancing ensure you don’t take too much risk, but by selling investments that have done well in favour of those that have done badly you are effectively selling at the top of the market and buying at the bottom. This is the holy grail of investing and something very few investors consistently achieve.”
How to handle gold
Central banks across the world have been hoarding gold at the fastest rate since 2012 and advisers expect more investors to join them as people react to growing fears about global volatility and the potential for a downturn in financial markets.
“Gold is a good diversifier for investors,” says Adrian Lowcock, head of personal investing at Willis Owen. “It doesn’t perform well when the outlook is positive and markets are going upwards but it comes into its own when investors are wary and markets more volatile.”
He explains that it is one asset class that investors turn to when they are looking to protect their capital from falling markets. “The long-term performance of gold has been good at protecting against inflation, but in the last few decades the price rocketed as investors could access and speculate on the metal more easily,” says Mr Lowcock.
Investors can either buy gold direct or purchase shares in gold miners. A gold exchange traded fund will generally closely track the gold price, while miners’ shares can be much more volatile, in the short term tracking stock markets but following the gold price over the longer term.
Gold miners’ shares also tend to exaggerate movements in the underlying gold price, as a 10 per cent rise in the gold price could boost profits of a gold miner by more than 10 per cent.
For investors looking for gold exposure, Mr Lowcock likes the BlackRock Gold and General fund or ETFS Physical Gold fund. The latter, an ETF, closely tracks the gold price but there are costs for storage and insurance.
Not everyone is a fan. Mr Connolly at Chase de Vere says gold produces no income, interest or dividends. “Essentially it just sits there. The price of gold therefore depends solely on demand and supply and how much people will pay for it.”
Despite its perception as a safe haven, he says gold has proven itself a volatile asset over many decades, subjecting investors to big gains or losses often over a short period. The price of gold reached over $1,800 per ounce in 2011, yet fell to around $1,100 at the beginning of 2016. It currently stands at around $1,200. “This is very volatile performance for a supposedly safe asset class,” warns Mr Connolly.
Putting money into today’s markets is an unnerving task. With interest rates on the rise, stock markets near record highs and political risk abounding, even the most qualified money managers are feeling edgy.
Investors should not take bad headlines as a sign to run for the exit; after all, volatility can bring with it opportunity. But now looks like a particularly good time to revisit financial goals and review the range of assets in your portfolio.
Additional reporting by Lucy Warwick-Ching
Low volatility funds
Low volatility funds designed to protect investors from the sharpest stock market gyrations have become a mainstay of the world of passive investing, as investors have sought protection against market falls.
These low-cost, exchange traded funds mimic indices such as the S&P 500 but only include the least volatile parts of the market. When markets are taking a dive, such funds should lose less — but on the way up they will deliver lower returns than a conventional fund tracking the same region or asset class.
In recent periods of volatility, low volatility ETFs have more than earned their crust, having not only lost less than the big benchmarks but in many cases outperforming them.
Over one year, iShares Edge MSCI Europe Minimum Volatility fund has lost just under 2 per cent compared with a fall of 7.4 per cent for the MSCI Europe index, a popular benchmark of European equities. Over five years it has returned almost 10 per cent more than the MSCI Europe.
The same is true of iShares Edge MSCI World Minimum Volatility, which has beaten the return of the MSCI World index by more than 10 per cent over five years. Over three months it has delivered positive returns, compared with a loss of 3.5 per cent for the MSCI World index.
Such funds, however, have yet to experience a sustained period of rising interest rates. As they are constructed using past data, they remain open to the risk that the least volatile stocks of the future are different from the safest stocks of the past.
“Investors shouldn’t be of the view that these strategies provide a guaranteed solution to a complex problem,” says James McManus, head of ETF research at online wealth manager Nutmeg. “Volatility dynamics in markets change over time, and it’s important to understand the strategies are weighted based on past volatility behaviour.”
Oliver Smith, portfolio manager at IG, adds: “[Low volatility ETFs] are still to be fully tested in markets with persistently rising interest rates, which will be a true test of their worth if the next bear market is interest rate driven.”
So-called “low-vol funds” have performed particularly well in a period of ultra-low interest rates but some have started to lag behind the main benchmarks since rates began to rise.
Mr McManus says: “While [it is] only over a short timeframe, the MSCI USA minimum volatility index has underperformed its market cap weighted equivalent since the Fed began to raise rates at the end of 2015.”
Low volatility ETFs are not designed to beat markets in all conditions, but protect investors on the downside. Mr Smith says they have a role to play in diversifying a portfolio: “To date these ETFs have proven very effective at offering holders consistently lower volatility returns than a market cap index, experiencing lower peaks and troughs over the past 12 months.”
However he warns investors should not own them in the belief that a minimum volatility fund will outperform a market cap index in absolute terms over the long run.
Low-volatility ETFs also tend to be marginally more expensive than conventional ETFs, but are still cheaper than active funds.
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