Fund routes to protect portfolios from further turbulence

“You’re going to need a bigger boat,” Brody’s famous understatement on encountering the great white shark in Jaws could be useful advice for investors in the current market. In this case, the predator coming for portfolios is a combination of mounting geopolitical tensions in the Middle East, ongoing conflict in Gaza and Ukraine, and the end of the pause on reciprocal tariffs. A bigger boat – a bit of market protection – is needed.

But where to get that? Historically, there have been a few reliable options: the US dollar, for example, or US government bonds. Gold has been a stalwart in times of crisis. Within the stock market, investors might look at defensive sectors, such as utilities or healthcare, to protect themselves against market gyrations.

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The problem today is that these safe havens don’t look very safe anymore. Simon Evan-Cook, manager of the Downing Fox multi-asset funds, says: “If there were attacks in the Middle East, normally, an investor could rely on the US dollar to go up versus UK sterling, but that protective effect has been notably absent during the recent tension.”

Are tech shares a defensive play?

The weakness in the dollar dents the safe-haven status for other US assets, such as treasuries (US government bonds). Equally, while US technology companies arguably have defensive characteristics – long-term revenues, high cash generation, powerful network effects – Evan-Cook is sceptical. He says: “If anyone thought the US technology giants were defensive, they would have had a rude awakening since the start of this year. Quite often in markets, there’s an area that people believe is defensive, but may in fact be signalling a problem.”

He says some assets can give the illusion of stability, due to being popular for a long period. That stability can breed instability. “If investors pile in to a specific asset, it will push up prices. They think it isn’t risky, and take fewer precautions.”

This becomes self-reinforcing, and ends up creating something extremely risky because expectations are so high. In his view, this is the situation with the US technology giants, where high valuations make them poised for greater volatility.

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Go for gold?

Gold is also a difficult call. After an astonishing rise to its peak of over $3,500 in mid-April, gold has been treading water throughout the recent volatility.

Lucie Meagher, private client investment director at Tyndall Investment Management, outlines that while it may still have a place, its role is more complicated. “The gold price could still go higher if geopolitical tensions escalate from here. While gold can sell off at the beginning of a market correction, it usually displays its defensive properties if markets falls are more sustained as we observed in both the financial crisis and the sell-off during the pandemic.”

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Within stock markets, it is a similarly complex picture. Traditional defensive areas have some drawbacks. Utilities look highly indebted, and vulnerable to higher-for-longer interest rates. The same is true for infrastructure. Healthcare has been very weak over the past three years and remains in thrall to the complexities of the US healthcare system under its new boss, Robert F. Kennedy Junior, the vaccine sceptic.

Against this backdrop, where can investors turn for safety? First, it’s important to say that no single asset class will protect against every type of risk. David Coombs, head of the multi-asset team at Rathbones, says: “When your potential safe havens aren’t looking good, what do you do? There are other safe havens, but there is no one safe haven. There are certain assets that will protect you eight or nine times out of 10, but there’s not one that works every time.”

The case for gilts

Government bonds still have a role. UK government bonds have some added tax benefits for UK investors as gains are not subject to capital gains tax if they are owned directly. Evan-Cook agrees that gilts still have a protective role in some circumstances, particularly in a conventional recession where the economy is weak and interest rates are falling. However, as 2022 showed, they are unlikely to prove defensive during an inflationary shock.

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Protecting against inflation is a tougher call. Meagher points out that historically bonds have demonstrated a positive correlation to equities when inflation gets above 2.5%.

“For a higher inflation environment, I would suggest owning commodities as inflation is often driven by higher commodity prices. Invesco Bloomberg Commodity ETF GBP (LSE:CMOP) provides a broad exposure to a basket of commodities including oil and gold.”

Another option, which appears in interactive investor’s Super 60 list of investment ideas, is WisdomTree Enhanced Commodity ETF - USD Acc GBP (LSE:WCOB). 

Oil-exposed ETFs

Coombs makes the case for exposure to oil to provide a protective role: “If the US bombs Iran, the oil price tends to go up. We have a strategic long-term allocation to oil, holding it as a long-term diversifier in certain scenarios. Oil tends to rise when there’s high geopolitical risk in the Middle East.” Investors can either invest directly in oil companies, such as iShares S&P 500 Energy Sector ETF USD Acc GBP (LSE:IESU) or SPDR® MSCI Europe Energy ETF GBP (LSE:ENGE), or in the oil price such as through WisdomTree WTI Crude Oil ETC (LSE:CRUD) or WisdomTree Brent Crude Oil ETC (LSE:BRNT).

Value funds

Finding lower-volatility parts of the stock market is a tougher call. Value funds should naturally be more protective because they avoid overpriced securities. But, says Mark Preskett, senior portfolio manager at Morningstar Wealth, investors need to be careful: “Certainly, it’s true that when a stock or market is cheap, it has less far to fall. Certain value managers specifically aim to be defensive by looking for robust dividend growth and is very focused on value.”

However, he says deeper value funds, such as Schroder Recovery, may not prove as protective. “They will tend to sail closer to the wind and can see volatility. They may dip into smaller companies and pick those very out of favour.” Therefore, value funds are not necessarily “defensive”.

Nevertheless, Meagher agrees that looking for areas where valuations are less stretched is likely to be a defensive approach, adding: “The Polar Capital Healthcare Opports fund would be a way to get access to this theme. Utilities is another sector that has displayed defensive properties in previous market cycles.

“While companies in this sector are highly indebted and there are some areas that should be avoided, there is significant divergence within the sector and therefore still some opportunities. This is a current theme for the Latitude Horizon Fund.”

Multi-asset fund that’s navigated choppy waters  

Alex Farlow, associate director of multi-asset research at Square Mile Investment Consulting and Research, likes the Troy Trojan Fund, managed by Charlotte Yonge and Sebastian Lyon: “It is a multi-asset strategy which follows a tried and tested investment process with a long-term approach, which places an importance on asset allocation combined with stock selection.”

“It is predominantly invested in traditional assets as well as gold or gold-related investments although this exposure has been an area they have been trimming on share price strength more recently. Over the long term, the fund has provided returns that have been significantly ahead of equities with a much lower level of volatility.”

The managers are patient, aiming to preserve investors’ capital during periods when risks are high and take on more risk when the risk-return potential is more favourable.

Other options include Personal Assets Ord (LSE:PNL), the sister fund to Troy Trojan. This is one of the small number of wealth preservation investment trusts alongside Capital Gearing Ord (LSE:CGT) and Ruffer Investment Company (LSE:RICA). Each trust invests in a variety of defensive assets, with low exposure to shares.

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How to construct a portfolio to reduce downside risk

Ian Rees, head of multi-manager funds at Premier Miton Investors, suggests defensiveness can also be achieved by the right blend of assets: “True diversification is the starting point, followed by not overpaying for any exposure. For broad portfolio insurance, there isn’t any single defensive asset that is reliable enough to fulfil the role by itself. Investors need to access a broad suite of alternative exposures to achieve that aim.”

Debbie King, investment manager at Aegon AM, highlights the importance of income as a stabilising force: “The inherent stability of income offers real comfort to investors, a reliable anchor for broader total return. That ‘anchor’ is particularly strong when, like now, bond yields are attractive. We don’t accept the premise that investors should ignore all the usual defensive options – it’s not just about what we buy and sell but how we do it.”

Rees and Evan-Cook urge investors not to forget about cash. While it’s not a good long-term option for growing wealth, it provides some stability, interest rates are relatively high and it allows investors to exploit market opportunities as they arise. For investors looking for that bigger boat, to defend themselves against the predatory shark, it definitely has a place.