How investors can protect their gains

There will be those who, through skill and good fortune, have hung on to the lion's share of their investment portfolios over the past three years.

However, the credit crunch and the policy responses have created such an unusual, and unprecedented, investment environment that few can be confident of repeating the trick over the next few years.

On one hand, this year's Barclays Equity Gilt Study suggests investors have made nothing out of equities over the past 10 years. But with developed market sovereign risk at an all-time high, government bonds look unappealing.

Fixed income

Corporate bonds have been unusually volatile and valuations look rich. What are the choices for those looking to preserve capital without simply riding out volatility?

Fixed income is the traditional route to protecting gains, but huge borrowing by developed market governments has raised the stakes in sovereign debt to the point where several large nations are either at risk of a downgrade or of defaulting on their bonds.

In the UK, the gilt market faces downward pressure as the Bank of England withdraws quantitative easing, and it is vulnerable to a downgrade by credit rating agencies until politicians develop a credible plan to cut public spending.

Equally, corporate bonds look less attractive after a strong run of performance saw the average UK corporate bond fund rise 19.9% over the past 12 months. Continued outperformance of this magnitude seems unlikely and, at worst, valuations now look too high.

Bob Yerbury, chief investment officer at Invesco Perpetual, says: "The recent past has reminded investors that they can lose as much money in fixed income as they can in equities."

Leaving the money in the bank

And then there is cash. Yerbury argues that the biggest risk for investors is to leave their money in the bank, earning nothing and being eroded by inflation.

In January, inflation was running at 3.5%. The best instant-access savings account was paying just 3% before tax.

What are the options to deal with this environment? For those who prefer to stick with a more traditional blend of asset classes, it is a case of taking a smarter approach to risk management and diversification than simply looking at recent history.

David Jane, head of equity investment at M&G Investments, says: "A lot of rubbish is talked about risk.

"Risk tends to be the worst thing that happened yesterday. Models are good for chemical processes, but investment management just doesn't work that way."

He believes it comes down to taking a "real world" view of risk and being aware that risk has a relationship to valuation – if things are cheap they tend to be less risky.

Jane says it is important not to be too blinkered and to incorporate more than one view into a portfolio. He adds: "We don't know what will happen next, but we know the balance of probabilities.

"We don't want to be positioned where if we're right we do fabulously well and if we're not everything goes wrong."

The appeal of equities

With a real world view of risk, equities may not look so unappealing. Yerbury says the picture from the Barclays Equity Gilt Study is misleading: "From 1980-81, there was an extraordinary rise in equities and by 2000 they were really overvalued.

"Now we are only just emerging from recession. Over a 20-year period you have never lost money in equities. If an asset class has done nothing for 10 years that is not the time to give up, that's the time to invest."

It is difficult to make a case for most areas of the fixed income market, but emerging market debt offers one solution.

Mark Harris, head of multi-manager at Henderson New Star, has stuck with buying the debt of those countries with surpluses, largely in emerging market countries and Asia.

There are several successful emerging market debt funds, including those from Investec, Fidelity and Threadneedle.

A number of investment managers protected capital in the difficult markets of late 2007 to early 2009. Mick Gilligan, head of research at Killik & Co, points to Philip Gibbs at Jupiter, whose Financial Opportunities fund rose 1.7% in 2007 and 7.3% in 2008.

Some 204 funds lost less than 5% in the downturn of November 2007 to February 2009, of which more than half were fixed income funds.

Among the remainder, there was no fund in the UK all companies sector, but two in the Japan sector, two in biotechnology, four in balanced managed, and five in the cautious managed sector.

Picking funds

Picking those funds would have taken considerable skill, and the majority of non-fixed income funds that preserved capital were absolute return funds. These are the latest and most successful attempt to bring hedge fund-like returns to the retail market.

Absolute return funds tend to be benchmarked to cash and have generally delivered as promised. Only one fund in the IMA absolute return sector has lost money over three years: the Elite LJ Absolute Return portfolio, down 5.8%.

The average fund is up 14.2%. Gilligan says: "A typical equity fund will have an exposure of 100%, whereas an absolute return fund will have exposure of between 0 and 50%.

These funds have generally worked to preserve capital, and have not sustained losses over any period of more than 5 to 10% even when markets have been down more than 30%."

He adds that most absolute return fund managers will protect capital even over relatively short periods: "In practice, most managers are looking over relatively short periods, otherwise they will fail to attract capital."
Gavin Haynes, investment director at Whitechurch Securities, says each fund will have different risk controls and positive returns are not guaranteed, but plenty of funds in the sector are grinding out steady returns.

Gilligan likes the BlackRock UK Absolute Alpha and Cazenove UK Absolute Target funds.

There are more esoteric solutions to the problem of short-term capital preservation.

James Daly, investor centre representative at TD Waterhouse, says: "Selling off a portfolio because you don't like the look of the equity market for the next year is a huge undertaking for a private investor, and it's fiddly and expensive."

Tax reasons

Private investors may not want to sell out for tax reasons.

For these investors, Daly suggests a number of options. First, the covered warrant, which can act as put options on single stocks or bonds and indices.

If the market falls, investors exercise the option and the money made from the option compensates them for losses on the long-only investment portfolio. The downside is limited to the price of the option because it does not have to be exercised.

Websites such as Société Générale's warrants site can help determine the type of warrants needed.

Investors can use contracts for differences or spreadbets. Here, they put down a deposit and can go short on the market. But this can be dangerous. If the FTSE 100 rises, losses are – in theory at least – unlimited as the FTSE 100 could continue to rise ad inifinitum.

Although investors should be protected by the rises in their underlying portfolios the hedge must be perfect. It is not enough to hedge the FTSE All-Share when the underlying portfolio is in the FTSE 100.

Most professional investors only use these techniques in a crisis. Yerbury says: "It could cost up to 3% per year to hedge losses using futures. Such is the power of compound interest it isn't worth doing this for any length of time. I would only do it if I were near retirement."

Capital protection solutions are available, but there is no magic wand. For every risk hedged something is sacrificed.

Are structured products an alternative?

In their best incarnation, structured products should offer a halfway house between cash and the equity market. They generally promise a certain level of return, related to the performance of an index, but with the security of a capital return after a certain number of years.

Structured products have been dogged by controversy. 'Precipice' bonds got their name because investors lost £2 for every £1 fall in the index if it dropped below a certain point.

Then came Lehman Brothers. The investment bank had been the counterparty on a number of structured products and many investors found their 'guaranteed' products were worthless when the bank went bankrupt.

Counterparty risk assessment has been tightened, with many issuers now looking to daily prices on the credit default swap market to judge default risk rather than behind-the-curve credit rating agencies.

The trouble for many investors is they require tying up money for five years or more so do not solve the short-term problem of capital preservation. They also tend to be expensive.

This article was originally published in Money Observer - Moneywise's sister publication - in April 2010