Only a third of funds deemed ‘cautious’ have managed to avoid losses this year, data shows. This will be of particular concern to more nervous investors – especially those who have taken a more cautious position following a turbulent period for global stock markets.

Figures from financial data firm FE Trustnet show that just 19 funds within the Investment Association universe with a cautious investment style have provided a return in excess of one per cent this year (numbers correct to 15/09/15), while only 46 out of the 150 funds have avoided losses this year.

The question is: how should more conservative investors respond?

Reviewing risk 

The Investment Association dumped the official ‘cautious’ fund label in 2011, but FE Trustnet defines cautious funds as products “designed to steer investors away from riskier parts of the market”. As a result, these funds have low exposure to equities, and higher allocation to bonds.

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Thanks to today’s low interest rate environment, the proposition offered by cautious funds – “ to lose a little, to gain a little” – is challenging, both for cautious savers and fund managers.

“While we remain in a quantitative easing environment, the majority of funds with higher allocations to cash, gilts and bonds are likely to produce returns beneath inflation,” says Andy Scott, deputy chief investment officer at Seven Investment Management.

In light of current conditions, Scott believes cautious investors should review both their portfolios and their risk profiles.

His view is shared by John Kelly, director of client investments at fund manager CCLA.

“The goal of portfolio construction is to match assets to your objectives. If you look to your portfolio to protect your assets from inflation and deliver a reasonable, growing income, now is maybe a good time to ask whether a cautious fund is the best vehicle for achieving that,” he says.

Allocation

Scott suggests upgrading to a comparatively higher – but moderate overall – risk exposure within a diversified portfolio, to mitigate volatility. Potential investments he cites include Real Estate Investment Trusts (REITs), property and corporate bonds.

REITs are a common inflationary hedge (as is property), and most offer a direct dividend yield.

Corporate bonds, debt issued by companies that act as IOUs, can offer yields as high as 14 per cent. Bonds are priced according to risk and longevity (the riskier/longer duration, the higher the yield), although longer-maturity corporate bonds are vulnerable to interest rate increases. Rises will place upward pressure on yields, and downward pressure on prices – meaning investors moving to reduce their exposure may get a poor deal.

Kelly also favours a diversified approach which incorporates alternative assets.

He cites mezzanine finance (a hybrid between bonds and equities), new varieties of property (such as student accommodation) and alternative energy sources.

“These are all strong diversifiers that provide a regular income, and their performance is not impacted by markets,” he explains.

Kelly also believes equities – typically branded a risky asset – may be safer than fixed income vehicles given current circumstances.

“UK government bond yields have never been so low – today, a 10-year bond yields at 1.83%, which means not receiving the full coupon for a decade,” he explains.

“During that time, you receive an annual return below inflation targets. The world could also change significantly – two general elections will take place between then and now, for instance – and you may suffer capital loss.”

He also believes equities represent a value prospect in the present conditions.

“Markets are not cheap, but valuations have been much higher in the past. There’s scope for further growth, so be on the lookout for individual stocks – with rising profits and dividends, strong market positions and decent balance sheets.”

Look before you leap

Experts believe, however, that cautious funds should not be dismissed outright and that they can still offer investors value – even in the current climate.

“They [cautious funds] are still relevant for people who won’t tolerate any volatility and aren’t so concerned about the risk of inflation – savers who only care about nominal gains, and cash protection,” says Scott.

“Although, maintaining a high allocation to safe assets will still ultimately erode your purchasing power – it won’t be fast, but it will happen.”

Laith Khalaf, senior analyst at Hargreaves Lansdown, believes cautious funds remain a good fit for conservative investors, and those with a limited investment horizon (ie those approaching retirement) – “who cannot handle, or cannot afford, a 20 per cent drop in their portfolio”.

“Whether you stay with a cautious fund depends on how much you’re willing to lose, and how much you want to gain,” he says.

“There’s less upside, but less downside too – you can expect a smoother ride overall. In a market sell-off, you can expect them to perform better and lose less than riskier funds – even if that doesn’t translate to a positive return.”

Khalaf contests the idea equities are necessarily safer than government bonds, noting while the outlook for bonds is “precarious” at the moment, there is no bond sell-off on the horizon.

“On the other hand, we’ve just seen a big correction in the stock market resulting from major fallouts in China, and the mining sector,” he says.

“The market could always fall further, but if there is an economic crisis, bonds will protect you.”

Nonetheless, Khalaf urges cautious investors to look at the funds they invest in to ensure they are performing adequately, and move to a different fund if necessary.

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