Interactive Investor

Why cautious funds failed to deliver in 2022

19th December 2022 11:05

by Kyle Caldwell from interactive investor

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We explain why, on the whole, low-risk funds have disappointed this year – with some losing more than 10%. 

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Unless investors had exposure to energy shares, energy funds or some renewable energy investment trusts, it has been a miserable year, and there’s been far more losers than winners.

Particularly striking is the lacklustre performances of funds designed to be low risk. This is explained by the poor performance of bonds in 2022, a result of a steep declines in bond prices as interest rates rose in an attempt to cool inflation.

UK government bond funds big fallers

In particular, this led to steep declines for two bond fund sectors considered to be the most cautious. Since the start of 2022, the average UK gilt fund has lost 21.8%, while the typical UK index-linked gilt fund is down 33.9%.

The lesson for investors is that even safe bond funds can fall sharply over a short-term period when there is an unfavourable market backdrop, which has been the case for bonds because of rising interest rates. UK government bond funds or gilts are considered among the safest type of bond fund investors can buy – due to the fact that the issuer is the UK government, which has never failed to return to investors the amount they have loaned.

But, due to interest rate rises, bond prices have fallen. In the case of UK government bonds, the yield – the income paid to investors – was very low. It was below 1% a year ago, so the price of such bonds were very expensive. As rates have risen, the fall in the bond price has been notable, as bonds re-priced.

The poor performance of index-linked bonds may have even surprised more seasoned investors, given that such funds pay a level of interest linked to the current rate of inflation in the market where the bonds are issued. At times of high inflation, such funds are a natural inflation hedge.However, in a rising interest rate environment, inflation-linked bonds are highly vulnerable, due to being “long duration”, and the performance of such funds reflected this during 2022.

In short, UK inflation-linked bonds typically take a long time to mature, often more than 20 years. Bonds with long lifespans have long “durations”, which are most sensitive to interest rate rises.

Duration refers to the sensitivity of a bond, or bond fund, to any change in interest rates. For every 1% rise in interest rates, a bond’s price will fall by about 1% for every year of duration. 

More bonds, more losses in 2022

Usually the ‘safest’ of the four multi-asset sectors – the Investment Association (IA) Mixed Investment 0-35% Shares sector – would be expected to best protect capital when stock markets are volatile, due to having only a small weighting to shares.

However, due to how severe the bond market sell-off was as rates rose, this has not played out in 2022, and the more bonds held in multi-asset funds, the worse performance has been.

As the table below shows, multi-asset funds with up to 35% in shares, and the remainder in bonds, have produced steeper losses than rival sectors. The average fund in this sector is down 10% year-to-date.

The best-performing multi-asset sector so far this year is Flexible Investment. Funds in this sector have no constraints regarding their exposure to shares.

How lower-risk fund sectors performed in 2022 

Fund sectorSector average return (%)
Targeted Absolute Return-0.9
Flexible Investment-8.7
Mixed Investment 20-60% Shares-8.8
Volatility Managed-9.3
Mixed Investment 40-85% Shares-9.4
Mixed Investment 0-35% Shares-10
UK Gilts-21.8
UK Index Linked Gilts-33.9

Source: FE Fundinfo. Data from 1 January 2022 to 16 December 2022. Past performance is not a guide to future performance.

The same trend applies to the popular passively managed Vanguard LifeStrategy fund range. Vanguard’s ready-made portfolios hold a collection of index funds and exchange-traded funds (ETFs). Each LifeStrategy fund holds a different proportion of shares, ranging from 20% to 100%, with the remainder in bonds.

In 2022, the five funds in the range have not performed in line with their level of risk, as the 20% version has produced the biggest losses, followed by the 40%, 60%, 80% and 100% options. A larger ratio to bonds has dented returns.

Vanguard LifeStrategy: lower-risk funds lose the most in 2022 

FundReturn (%)
Vanguard LifeStrategy 100% Equity-6.6
Vanguard LifeStrategy 80% Equity-8.6
Vanguard LifeStrategy 60% Equity-10.5
Vanguard LifeStrategy 40% Equity-12.3
Vanguard LifeStrategy 20% Equity-14.1

Source: FE Fundinfo. Data from 1 January 2022 to 16 December 2022. Past performance is not a guide to future performance.

Volatility managed and targeted absolute return

Two other defensive sectors are volatility managed and targeted absolute return. Neither have great reputations, and the former hasn’t done much to change that year-to-date. The average volatility managed fund is down 9.3%. Such funds target a specific risk or volatility outcome.

The targeted absolute return sector has held up well, with the average fund down 0.9%.

The problem is that some funds in the sector are aggressive, for example shorting stocks, while others are plain vanilla in attempting to deliver slow and steady returns. This is reflected in the wide range of returns for the sector. In 2022, for example, the worst-performing fund is down 20%, and the best performer is up 40%. Most funds in the sector – around three-quarters – have lost money year-to-date.

Absolute return can mean different things to different people, as the definition tends to be based around the end result (“positive ‘absolute’ returns” is a common objective), rather than how the fund manager attempts to deliver this. Therefore, investors need to know what kind of journey they are going on, and whether they are cut out for the ride. So, looking under the bonnet is key to understanding which strategies are used by the fund manager.

In the main, there’s two distinctly different strategies in the sector: the hedge fund-like funds and the less complex, more conservatively minded funds that do not take excessive risks.

Wealth preservation investment trusts

There are a handful of wealth preservation investment trusts that prioritise protecting investor capital. Therefore, when there’s a stock market sell-off, such trusts should keep losses to a minimum. Three of the four trusts that invest in this manner have achieved this in 2022.

The standout performer has been Ruffer (LSE:RICA). As fund manager Duncan MacInnes pointed out in a video interview with interactive investor, the small part of the portfolio that holds unconventional assets paid off in 2022. The portfolio has just 14% in shares, a record low.

MacInnes said “payer swaptions”, which are investments that rise in value when bond yields increase, was the biggest contributor to returns. Other positive drivers of performance have been “put options” (profiting when share prices fall) on certain tech companies, including Tesla (NASDAQ:TSLA) and Apple(NASDAQ:AAPL). A third positive contributor highlighted by MacInnes is credit default swaps, which make money when the costs for companies to borrow rises.

MacInnes stressed that these unconventional assets are used “solely for protection, to look after the portfolio downside”.

He added: “And they are also a small bit of the portfolio. So they punch very hard, but they're usually less than 5% of the portfolio overall.”

Meanwhile, Capital Gearing (LSE:CGT) and Personal Assets (LSE:PNL) have made small loss year-to-date, -3.6% and -4% respectively.

Recent activity for Capital Gearing includes adding to UK gilts and index-linked gilts after their sharp sell-off following the mini-budget in September. It also sold some ETFs and used the opportunity to increase exposure to investment trusts on wide discounts. Capital Gearing, part of interactive investor’s list of Super 60 investments, holds 29% in funds and equities.

Personal Assets holds around 25% in shares, with most of its portfolio in low-risk bonds, and around 10% invested in gold. In a recent update, fund manager Sebastian Lyon explains why he continues to be bearish on the prospects for markets.

Lyon said: “We suspect the repricing of assets has further to go, but bonds have probably incurred much of the damage, at least for now. Credit will suffer from a weaker economy, so spreads over government bonds may still widen from here, but at some stage longer-dated credit may offer attractive returns.

“Equities have partially de-rated, but when bonds were at these yield levels before the Global Financial Crisis, stocks were considerably cheaper. The cost of capital has risen now and asset prices are yet to fully reflect this new reality.”

RIT Capital Partners (LSE:RCP), however, has seen its share price decline by 25.7% in 2022. As our recent analysis of the four wealth preservation trusts explains, RIT Capital Partners has a notably higher amount in equities compared to its rivals – at around two-thirds of the portfolio. Some of this exposure is to unlisted companies. While it is not a surprise to see this trust have a bumpier ride when stock markets are out of form, such a big loss will be hard to stomach given that it aims to deliver “reasonable protection in down markets”.

In addition, RIT Capital Partners publishes its net asset value only once a month, which can create some uncertainty over the valuations of the underlying holdings.

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.

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