Funds that provide shelter in a stock market storm

After three years of double-digit returns from global stock markets, some kind of wobble was on the cards, although as is often commonplace when stock market volatility picks up a new headwind emerged in the form of America’s Operation Epic Fury in Iran.  

While the humanitarian element of the conflict in the Middle East is most important, it seems a prudent moment to start building some defences into a portfolio.

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Moreover, geopolitical tensions are not the only headwind, with investors trying to make up their minds on the long-term impact of artificial intelligence (AI) and whether the world’s largest businesses are spending too much money in AI advancements.

As this educational article explains, when stock markets become more volatile, it’s important to keep a cool head and take a long view rather than making rash decisions.

It’s also worth considering the wise words of investment superstar Peter Lynch. The former Fidelity fund manager once said: “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.” In other words, it is generally a mistake to ship wholesale out of markets.

The first message to anyone looking to fortify their portfolio is the importance of diversification and to be mindful of concentration risk. Some investors have made the case that the US mega-caps are, in reality, defensive stocks – cash-flow generative, business critical, with predictable revenues. But the spending on AI and their recent volatility have made that argument difficult to sustain. Yet anyone with a passive holding in the MSCI World Index has over 70% in the US and around 25% of their investment in the US mega-cap technology companies. With an S&P 500 tracker, it’s closer to 35%.

James Harries, manager of the STS Global Income & Growth Trust Ord (LSE:STS), says: “When markets are strong, people worry less about volatility and downside risk seems less important. However, these factors are more relevant now than ever. The stock market is more expensive, more concentrated and more highly correlated. World indices now largely reflect the US market, meaning index and growth investors are increasingly exposed to the single theme of AI. For us, this calls for caution. People tend to press on the accelerator as they head towards the cliff, when you should probably do the opposite.”

With that in mind, anything that diversifies away from US technology will bring a defensive quality to a portfolio. Harries adds that some AI companies are still trading at 50x earnings: “Meanwhile, spirits companies are currently trading at lower multiples than tobacco companies, which would have been unthinkable not too long ago…So, while all eyes have remained focused on AI, we have been investing in high-quality, attractively valued global income companies such as Automatic Data Processing Inc (NASDAQ:ADP), Accenture Class A (NYSE:ACN), Canadian National Railway Co (NYSE:CNI), IG Group Holdings (LSE:IGG), Nike Inc Class B (NYSE:NKE), Novo Nordisk AS ADR (NYSE:NVO) and Siemens AG (XETRA:SIE).”

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Lucie Meagher, private client investment director at Tyndall Investment Management, says finding a defensive asset without missing out on returns is the holy grail of investment management, but she sees a number of ways to build protection into a portfolio: “Within your equity exposure, you could also look to increase your allocation to more defensive sectors where valuations look less stretched such as healthcare. The Polar Capital Healthcare Opportunities I Acc fund would be a way to get access to this theme.”

Another defensive option, notes Premier Miton’s Ian Rees, would be the insurance sector. Rees, the firm’s head of multi-manager, says: “One way to build defensiveness into a portfolio is to invest in companies that are less exposed to the economic cycle. These can be sectors that are more regulated in their return profile. That might be sectors such as the global insurance sector. These companies have reliable outlooks because they are heavily regulated and generally perform well when markets are moving around.”

Bonds are another natural defensive choice, but there are some caveats in the current market. High government debt has made government bonds more volatile, while credit spreads (the amount investors are paid for taking the risk of a corporate bond over a government bond) are at historic lows. This means there isn’t a lot of margin for error if things go wrong in the economy. Also, bonds have not been offering the same diversification from equities. This was particularly evident in 2022, when bond markets tanked alongside equity markets, but has also been evident in subsequent sell-offs.

Nevertheless, there are some parts of the bond market that still look reasonable. Alex Farlow, associate director, multi-asset research, Titan Square Mile, says the AXA Sterling Credit Short Duration Bond Z Grs Acc fund may appeal to investors who want to preserve capital over the longer term but for whom a level of income is equally important. It invests in short-dated corporate bonds which generate the fund’s income stream, and which tend to be less volatile than the broader corporate bond market. This fund, as well as others fishing in the same pool, offers slightly more risk than a money market fund, but in doing so the yields are typically higher.

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However, for those looking for lower-risk options, money market fund yields are offering inflation-beating income. Such funds tend to have yields close to the level of UK interest rates, which were held at 3.75% last week. Among the options are: Royal London Short Term Money Market, L&G Cash Trust, Fidelity Cash, BlackRock Cash, Vanguard Sterling Short Term Money Market and abrdn Sterling Money Market. 

Rees says he likes the “big bold beautiful” bond funds – such as the M&G Corporate Bond GBP I Acc fund: “They are high quality. If there are strong moves in the credit markets, they won’t keep up, but they should insulate investor portfolios.” He says that the recent hiccups in the private credit space, such as over Blue Owl, should give investors pause for thought.

Another option for investors may be a multi-asset fund, where the fund manager will flex the portfolio to be more or less defensive over time. Farlow says the Pyrford Global Total Return (Sterling) B GBP Acc fund is a good choice. It has three principal objectives: low volatility, positive returns over 12-month periods and to outstrip inflation over the long term: “It should tick a number of boxes for more defensive investors. It follows a simple and easily understandable approach, investing only in equities, sovereign bonds and cash, with the team focusing on their strengths, which we see as asset allocation and stock selection. In doing so, they aim to generate real returns without taking excessive absolute risks.”

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Meagher likes Ruffer Investment Company (LSE:RICA), which has delivered a 7% annualised return over the long term and has a strong track record of outperforming in more challenging market conditions such as 2022. For those who prefer an open-ended option, Farlow suggests the WS Ruffer Diversified Return I GBP Acc fund, which follows Ruffer’s core investment strategy: “It boasts a strong track record of delivering a return significantly in excess of cash over the past 30 years, and, importantly for those seeking a more defensive portfolio holding, has done so with less than half the volatility of equity markets.”

Two other wealth preservation investment trusts are Capital Gearing Ord (LSE:CGT) and Personal Assets Ord (LSE:PNL). The duo, alongside Ruffer Investment Company, has a low weighting to shares and plenty of defensive armoury, such as low-risk, inflation-linked bonds. As Kyle Caldwell, funds and investment education editor at interactive investor, says: “Each offers a steady, defensive option for investors seeking long-term real returns with controlled risk. As ever, investors need to do their homework and look under the bonnet to see how the defensive exposure differs – particularly the equity holdings, where the three trusts have less in common.”

While adding defensive funds to a portfolio will help, investors looking to build resilience in their portfolios need to consider the diversification and valuation of their existing holdings as well. Simply diversifying away from the US technology will be an important start.