There is increasing talk among investment professionals that we’re long overdue a market correction, namely for share prices to fall by 10% or more in a short period. While not trying to be pessimistic, we do believe now is a prudent time to protect the wealth you’ve created during the current bull-run.

We’ve previously discussed taking profit in the higher-rated stocks in your portfolio as one way of locking in profit. Another strategy is to consider switching some of your money into capital preservation funds.

This type of investment collective has two benefits. First, it has a good track record of helping investors to avoid large losses. Second, it can actually grow your wealth as well, albeit slowly.

A lot of people may think capital preservation funds are simply defensive investments. That’s not true. Many of the products have a good track record of delivering decent annual returns.

For example, RIT Capital Partners (RCP) achieved 14% annual return in 2013, 13.3% in 2014, 22.7% in 2015, 14.2% in 2016 and 5% in 2017, according to Morningstar data. Its strategy is to preserve shareholders’ capital AND deliver long-term capital growth.

Fund manager Peter Spiller says Capital Gearing Trust (CGT) has enjoyed a 185-fold increase in its share price in the 35 years he’s been running the fund. He credits the flexibility of asset allocation, saying there are many levers to pull to shift assets in accordance with valuation and/or opportunities for capital gains.

‘On a net asset value basis, I’ve only had one bad year in the last 35 and that was only down 2%,’ he reveals.

What’s in a capital Preservation fund?

Many capital preservation funds have a lower exposure to equities (namely stocks and shares) than a standard income or growth fund. Instead, portfolios are likely to have a large position in government and corporate bonds plus assets such as gold.

Their guiding principle is that generating more modest gains is a price worth paying for not suffering the bigger losses that come from greater risk taking.

Capital preservation is a money management strategy designed to avoid losing money at all costs, in which the protection of the wealth you have already garnered is deemed to be more important than generating additional growth or profits.

It is also sometimes taken to mean protecting the inflation-adjusted purchasing power of an asset, so that the pile of hard-earned cash an investor has amassed can still purchase the same goods and services by the end of the holding period.

What to expect from owning capital preservation funds

In general, capital preservation funds are likely to underperform a rising market, although investors should still participate in a good chunk of the upside. They should outperform in a falling market and hopefully have minimal or no losses – although the latter is never guaranteed.

Spiller at Capital Gearing Trust says his fund is designed to look after all financial assets for someone who has a long term view. He says it is aimed at people who choose returns in the form of capital gains rather than income plus have an aversion to losing money but would like to outperform the markets over time. That’s a good description which we’d apply to all capital preservation funds.

‘On a long term basis, these types of strategies can be appropriate for investors taking their first steps in the investment world as they offer an element of market exposure but often with lower volatility,’ says Ryan Hughes, head of fund selection at AJ Bell.

He warns that these types of strategies still have the potential to lose money and therefore investors worried about short term market volatility should tread very carefully.

‘Ultimately, these strategies are designed to be long term investments and should not be thought of as a “parking bay” for equity exposure when times are more challenging. If you are very worried about short term market conditions, then cash offers certainty that other investments just don’t offer.’

Ryan makes a good point that cash should be considered as a place for your money, particularly if you are very bearish.

‘If people are bearish then they may prefer to hold a lot of cash. But that won’t save you if there is rising inflation,’ comments Spiller. ‘You have to not mind underperforming markets during a bull run – but Capital Gearing Trust hasn’t fallen (most of the time) when markets were down in the past.’

Inflation can eat into the real returns on your cash. For example, inflation is currently 3% and the best paying easy access savings account currently pays 1.31% (offered by Paragon Bank). Assuming inflation stays the same, the real return on your cash in a Paragon savings account would be -1.69% after a year.

Some people might argue that’s a small price to pay compared to the potential losses you could incur in a stock market correction.

Why consider capital preservation funds now?

Following a prolonged rally in world stock markets, many of which are ‘priced for perfection’, prudent investors should now be placing an increasing emphasis on capital preservation.

As the global bull market is maturing, many experts are now prioritising the preservation of capital following a prolonged period of capital growth in both bonds and equities. The FTSE 100, S&P 500, Dow Jones Industrial Average, NASDAQ and Nikkei 225 indices are testing new highs, all of which is giving many experts the heebie-jeebies.

Among them is Howard Marks, the well-followed co-chairman of Oaktree Capital Management, who says investors should be wary of high-flying markets now but not panicky.

One of the most prominent voices raising concerns about the ongoing exuberance of markets this year, Marks recently said: ‘I think it would be a huge mistake for people to get nervous and fear that we’re heading for another crash’. A correction of 20% or 30% could still be ‘very unpleasant’ according to Marks, who warns investors not to interpret his calls to avoid panic to mean ‘there’s nothing worrisome going on’.

Marks said Oaktree’s investment team is approaching the current environment under the battle cry of moving ahead ‘with caution’ and Shares believes savvy investors should heed this advice.

Hughes at AJ Bell says it is crucial for investors to think about their risk profile, tolerance of potential loss and investment objectives. ‘When that is understood by an investor it allows them to consider which types of investment are suitable for them.

‘Funds taking a capital preservation approach can still have an important role to play even for investors seeking long term growth as they add useful diversification to a portfolio.’

He reiterates that this type of fund will often lag a rising market but will likely come into its own when times become more challenging.

A selection of capital preservation investment trusts

There are many investment trusts and open-ended funds with a capital preservation strategy including the aforementioned RIT Capital Partners, set up to manage some of the wealth of the Rothschild family, which seeks to preserve wealth through a multi asset approach.

Ruffer Investment Company’s (RICA) principal objective is to achieve a positive total annual return, after all expenses, of at least twice the Bank of England base rate. It invests in internationally-listed shares or bonds issued by corporates, supranationals or government organisations.

Managed by Hamish Baillie, Steve Russell and Duncan MacInnes, the fund aims to maintain returns under a range of market conditions, with assets allocated towards bonds, cash, gold and equities ranging from Lloyds (LLOY) to Walt Disney.

Relevant open-ended funds

Within the funds universe, Troy Asset Management is renowned for its distinctive method of investing that prioritises the avoidance of permanent capital losses through cautious asset allocation and careful selection of high quality companies.

Founded in 2000 by Sebastian Lyon, Troy’s first principle is that ‘those who have capital should concentrate on not losing it. We consider risk management to be the avoidance of permanent capital loss.’

Troy elaborates: ‘We are investors in long-term assets. Therefore our investing time horizon is long and we measure performance against returns available from keeping cash on deposit. We do not seek to manage risk by closely tracking a benchmark, hedging our risks, or going “short” investment securities (namely placing a bet that a share price will fall, upon which you make a profit).

‘Risk management is instead conducted through a conservative allocation of capital among high quality and easily traded securities, together with the selection of excellent businesses when they are available at reasonable prices.’

Lyon himself manages the Troy Trojan Fund (GB00B01BP952), which seeks to achieve growth in capital and income in real terms over the longer-term.

As at 30 September, the Trojan Fund’s asset allocation was 12% to UK equities, 24% to overseas equities, 8% to gold related investments, 29% in cash and with 18% and 9% allocated to US and UK index-linked bonds respectively.

Top 10 equity holdings include British American Tobacco (BATS), Microsoft, Berkshire Hathaway and Dr Pepper Snapple.

Lyon also manages investment trust Personal Assets Trust (PNL) which offers investors exposure to a defensive combination of high quality equities. Holdings include Unilever (ULVR), Coca-Cola, Colgate Palmolive, US and UK government bonds, gold and cash.

Shares in Personal Assets Trust have increased by 58% over the past decade, more than twice the 26% return from the FTSE All-Share over the same period.

Other funds with relevant styles

Another product from the Troy Asset Management stable is Troy Spectrum (GB00B2990B27). Strictly speaking it isn’t a capital preservation fund yet the fund manager centres on high-quality picks including stakes in many third party investment funds and has a firm eye on downside protection.

Fund manager Tom Yeowart explains: ‘We seek a growing long-term equity-like compound return with lower volatility, but we’re focusing on downside risk rather than trying to chase returns. We are trying to protect capital on the downside and keep up on the upside and we tend to do best versus the index during periods of market turmoil.’

‘We have a real focus on boutique fund managers and we tend to be long-term partners. We are picking truly active managers. Typically, they have a high degree of courage in their convictions. Where we find a manager we like, we want to hold them for the long term.’

Portfolio exemplars include Aurora Investment Trust (ARR), a concentrated book of high quality businesses bought at bargain prices and managed by Phoenix Asset Management’s Gary Shannon. Aurora invests in UK equities using a value-based philosophy inspired by famous investors Warren Buffett, Charlie Munger, Benjamin Graham and Philip Fisher.

Other Troy Spectrum positions include the TB Evenlode Income (GB00BD0B7C49) fund managed by Hugh Yarrow, which focuses on long-term total returns with an emphasis on income.

Elsewhere, investment trust Caledonia Investments (CLDN) is a less obvious contender for a capital preservation fund, yet one that is relevant in our view. Its aim is to grow net assets and dividends paid to shareholders over the long term, while managing risk to mitigate the volatility of return. It has a conservative approach.

Absolute return funds

Although bear markets and corrections can stoke panic, it is important to remember volatility also provides opportunities for investors to make profits.

One way of positioning portfolios for a correction is to put money to work with absolute return funds, which seek to make positive returns regardless of underlying market conditions.

Absolute return strategies provide an alternative prospect to traditional equity and bond funds as they can use a variety of instruments across different asset classes as well as a blend of short and long stock positions to generate positive returns from falling or rising markets.

Their number includes CF Odey Absolute Return (GB00B55NGR79) and Newton Real Return (GB00B7VVXF60). The latter uses a global thematic framework that identifies the key long-term forces of change and ways to invest in them.

It is important to note that absolute return funds are not low risk investment products. Their use of shorting strategies makes them high risk. Their bad years can be punishing, as illustrated by the 18.3% loss experienced by the aforementioned Odey fund in the 12 months to 31 October 2016.

Newton Real Return has a more consistent track record with positive returns in each of the past six years, as illustrated by the table included earlier on in this feature.

One final fund to consider

Admittedly, a smaller-companies trust might not seem an obvious downside protection pick, but Strategic Equity Capital (SEC) merits mention in this feature. A 12.4% discount to net asset value should also pique the interest of value-seekers.

The trust’s investment manager GVQIM is a specialist in applying private equity investment techniques to public markets, with a process that focuses on proprietary research and drawing upon the real-world input of an industry advisory panel of industrialists and private equity professionals.

Fund manager Jeff Harris seeks to identify high quality coveted assets with attractive cash flows from firms that are too small for the FTSE 250 at the time of purchase.

GVQIM believes SEC is better positioned in weaker markets than peers for a number of key reasons. For example its portfolio holdings, which include payments and administration play Equiniti (EQN) and teleradiology provider Medica (MGP), have strong balance sheets.

Harris’ focus on quality holdings with real intellectual property as opposed to domestic cyclicals means companies in the fund are coveted assets which may be acquired.

Finally, the trust doesn’t employ gearing (using debt to boost the portfolio) and typically has a net cash position which offers protection and capital to deploy when markets are weak and new investment opportunities arise. (JC/DC)

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