Interactive Investor

Defensive investments: fund and trust ideas for your ISA

In the final article of our three-part ISA ideas series in the run-up to tax year end, David Prosser explains how investors can gain exposure to defensive funds aiming to protect capital when stock markets fall sharply.

26th March 2024 09:20

David Prosser from interactive investor

This is the final article of our three-part ISA ideas series in the run-up to tax year end, the other two pieces can be read by following these links:

For investors of a nervous disposition, the beginning of 2024 has offered plenty to worry about. First, the economic news has been grim. The UK, we learned in February, slipped into recession during the second half of last year. And it is hardly alone; European Union countries including Germany are also in a downturn, with the European Commission cutting its growth forecasts for 2024.

Japan, too, has slipped into negative territory. Even in emerging markets, where growth rates are often much higher, the news is worrying; China, in particular, continues to falter.

Nor is the geopolitical backdrop showing any sign of easing. Conflict in Gaza is in danger of spreading across the Middle East, with attacks continuing on key shipping routes in the Red Sea. War in Ukraine is ongoing. The US and China continue to teeter on the edge of an all-out trade war.

As for looking ahead to the rest of the year, there are only limited crumbs of comfort on offer. The Bank of England may be in a position to cut interest rates in the coming months, but that’s dependent on inflation. The economic news from the US is better, but the forthcoming election is bound to cause anxiety. China, meanwhile, looks set to spend the year battling deflation.

Against this backdrop, investors thinking about how to use this year’s £20,000 Individual Savings Account (ISA) allowance before the end of the 2023-24 tax year on 5 April may well be focused on capital preservation. Those looking for more defensive investments may be doing so due to already having significant exposure to “risk-on” assets such as equities.

Where to look for defensive funds and trusts

In which case, which potential ISA investments offer at least some potential to generate returns – taking advantage of the tax-free income and gains you’re entitled to inside the tax wrapper – while protecting your capital?

The good news is that there are a number of collective investment funds that aim to achieve exactly those goals, emphasising downside risk management while still keeping an eye out for opportunities for upside. Typically, such funds invest across multiple asset classes, including equities, bonds, property and cash – and possibly alternative investments such infrastructure. They may even use derivatives as a tool to manage risk.

Capital Gearing Ord (LSE:CGT) trust, one of interactive investor’s Super 60 mixed-asset funds of choice, is a good option, says Alex Watts, an investment data analyst at ii. Its goal is to preserve and grow investors’ capital – to achieve returns, over time, that exceed inflation and therefore protect your wealth in real terms.

Veteran manager Peter Spiller has run the fund since 1982, although he now works alongside co-managers Alastair Laing and Chris Clothier. The team have the freedom to invest across a range of asset classes.

Watts says: “Rather than using exotic strategies or derivatives, the trust’s approach to avoiding drawdowns has been to hold a highly diversified portfolio of assets..

“Currently, the trust has a notable emphasis on index-linked government bonds, which comprise nearly 50% of the portfolio. These bonds can offer protection when stock markets fall, and work as a hedge against rising inflation because payments are adjusted in line with the consumer price index.”

While past performance is no guide to the future, Capital Gearing has generally delivered on its mandate. The fund has achieved positive returns in 16 of the past 20 years and beaten inflation in 15 of them.

A different approach to capital preservation, suggests Scott Gallacher, a chartered financial planner and director of independent financial adviser Rowley Turton, could be to focus on a narrower set of asset classes, targeting investments with defensive qualities. That is, investments with a tendency to show resilience during challenging periods.

“The Royal London Diversified Asset-Backed Securities Fund fund is a great choice for those who want to keep their capital safer,” Gallacher says. “It mixes asset-backed securities and bonds and is therefore relatively low risk. It is shown to have high alpha and low beta, meaning it doesn't just follow the market’s ups and downs.”

Effectively, this fund offers an alternative approach to diversification and risk management – asset-backed securities are instruments based on income-generating assets such as credit card and loan accounts. The fund is also a low-cost choice, with an ongoing charge of 0.43% a year, which represents less of a drag on returns than more expensive alternatives.

Ben Yearsley, director of Fairview Investing, also thinks both a more diversified fund and a targeted vehicle could be good ways to preserve capital. For the former, he picks Personal Assets Ord (LSE:PNL), an investment trust with a similar profile to Capital Gearing.

It’s my go-to fund for capital preservation,” Yearsley says. “There are no guarantees, but Personal Assets aims to maintain the real value of your wealth over time by buying government bonds, as well as high-quality equities.”

As for a more focused approach – if you already hold diversified funds, for example – Yearsley singles out Polar Capital Global Insurance. “It’s a dull, boring fund that consistently delivers year in year out, by investing in quality specialist insurance businesses,” he explains.

The case for going for gold

Elsewhere, it would be wrong to overlook gold as a potential defensive option amid the current uncertain market conditions, argues Tom Bailey, head of exchange-traded fund (ETF) research at HANetf. As Bailey argues, gold has long been regarded as offering a store of value during periods of high inflation and economic volatility – not least because you’re buying a physical asset. The gold price rises and falls, so your capital is at risk, but the precious metal has often performed strongly in tough periods against other types of assets.

Bailey says: “Investors protecting themselves against systemic financial risk sometimes shun exchange-traded funds providing gold exposure, because the gold backing these funds is held by the big-name banks.

“But our Royal Mint Responsibly Sourced Physical Gold ETC (LSE:RMAU) fund is different, with the gold backing it held in The Royal Mint’s vaults in Wales, outside the financial system.”

Alternatively, moving into the ETF sector also gives investors the option of a more complex approach to capital preservation, which has caught the imagination of some advisers in recent times, particularly in the US.

The risks with inverse ETFs

A number of ETF managers now offer “inverse ETFs” – using derivative holdings, these rise in value when the index they track falls. Some of these funds come with leverage – that is, they take on borrowing to amplify their returns.

That combination opens up an intriguing possibility. If most of your portfolio is in conventional investments where you’re worried about the near-term outlook, you could use a leveraged ETF to hedge against the risk of those assets falling. This way, you can invest a smaller proportion of your portfolio in the fund to protect against setbacks on the larger proportion.

So far, so good, but this strategy comes with risks attached. Leveraged funds will automatically be more volatile – and there is plenty of scope for things to go wrong. For this reason, you’ll need to pay close attention to your portfolio – and unless you’re a sophisticated investor, you may need professional advice to pursue this approach to risk management.

Keeping it simple

If you prefer a plain-vanilla approach to capital preservation, it may be simpler to stick to a large and conservatively managed fund that aims for growth without taking too many risks.

In this context, Tomiko Evans, chief investment officer of Crossing Point Investment Management, is a fan of Alliance Trust Ord (LSE:ATST).

“It is one of the oldest and largest UK investment trusts and invests primarily in global equities,” she explains. “Alliance has been one of the top dividend heroes among investment trusts with dividends increasing for 57 consecutive years; it is also currently trading at a discount, so would provide exceptional value.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.