In recent weeks US indices have traded higher than at the start of the year, almost as if a global pandemic never happened. A few other markets have recovered nearly all of this year’s lost territory, such as Germany’s DAX index.

Markets are forward looking and are now eyeing the prospects for recovery and the capacity of a vaccine or new treatment to help lift us out of a Covid-19-induced malaise.

However, it would be naïve to think there is no chance of another correction either linked to coronavirus and its aftershocks or some other issue like rising unemployment, ballooning corporate debt, the US presidential elections or escalating tensions between the West and China.

We don’t feel it is time to sit back and relax about markets. As such, more nervous investors might appreciate some insight into how to protect their portfolios from another downturn.

A summer or autumn correction looks plausible so rejigging your investments now could help to preserve some of your wealth and also give you the means by which to snap up any good stocks or funds if their price suddenly becomes a lot cheaper, just like we saw earlier this year.

HOW TO PREPARE FOR A DOWNTURN

In this article we discuss some ways of protecting your portfolio against further volatility. We talk about traditional things in which to invest for uncertain times as well as what you should be avoiding at all costs.

We also consult some experts on how they go about managing clients’ money in a volatile market and how you should think about asset allocation.

A crucial point to remember is that you shouldn’t overreact to events. Anyone who sold equities in a panic when markets sold off in earnest in March would have crystallised a loss ahead of an extremely rapid recovery for much of the market (though not all).

For most of the stocks which didn’t enjoy a recovery there are some key factors at play. Their area of business is likely to have been irreparably damaged or disrupted by the pandemic and/or they have a weak balance sheet and are therefore unable to weather a period of depressed demand.

If this is true for any names in your own portfolio you need to think carefully about whether they should still have a place within it. The shares may now be cheap but there’s a good chance they will remain so or get even cheaper (potentially into oblivion) unless they can demonstrate that balance sheet problems can be fixed or, if necessary, adapt to the new post-corona realities.

A ROLE FOR CASH

One simple thing every investor could consider, beyond finding specific safe havens or long-term winners, is to build a pot of cash which can be used to buy into future dips in the market. Selling off stocks which aren’t fit for the future could be a good start in terms of amassing some funds.

If the recent sell-off was any guide then indiscriminate selling created lots of opportunities to buy quality investments at knockdown prices. Despite being seen as a beneficiary of coronavirus due to its focus on health and hygiene products, even Reckitt Benckiser (RB.) sold off heavily, hitting a low of £51.30 in mid-March. At the time of writing it has recovered very well and trades at nearly £80.

Equally you shouldn’t be buying into the momentum enjoyed by every perceived coronavirus winner. Vanguard’s head of product specialism Mark Fitzgerald says: ‘Buyer beware, be careful of being attracted by short-term performance. You want to have a look at the situation over three, five, seven, 10 or even 20 years to get a real sense of where to place your risk.’

PORTFOLIO PROTECTION - WHAT TO BUY

BUY a capital preservation fund

Some of these products have a very good track record of protecting investors against loss. A great example is Personal Assets Trust (PNL) which delivered a 5.3% increase in net asset value in the year to April 2020 when the wider UK market fell 20%.

BUY a gold ETF

Gold has solid safe-haven credentials, particularly when measured over months or years. You can get low cost exposure from iShares Physical Gold ETF (SGLN) which has an ongoing charge of 0.19%.

BUY a quality-focused fund

While quality stocks don’t tend to be cheap there is a reason they perform well over the long term.

Typically, they invest in companies delivering a product or service for which there is significant and growing demand. These companies should also enjoy strong barriers to entry and generate lots of cash flow to reinvest in the business, build a cash buffer for tough times and return to shareholders through dividends.

Investors looking for diversified exposure to quality firms with growth potential could consider mid-cap specialist Smithson (SSON), run by asset manager Fundsmith.

BUY a strategic bond fund

When it comes to fixed income, flexibility is a good idea with some parts of the bond market offering very low returns. We like Allianz Strategic Bond Fund (B06T936) which leans on the significant expertise and resources in this area enjoyed by asset manager Allianz.

ASSET ALLOCATION

Some observers think investors should change the way they think about asset allocation and that the traditional approach of having 60% of the portfolio in stocks and 40% in bonds might no longer be relevant.

Berenberg’s equity strategist Jonathan Stubbs says a 40:30:20:10 approach might work better. This involves 40% in select equities, 30% in bonds, 20% in a ‘liquidity’ hedge like gold or bitcoin, and 10% in alternative assets such as industrial metals, renewables, lumber or certain categories of real estate.

In terms of the equity component, Stubbs adds: ‘We see three key ways to future-proof portfolios: 1) fiscal activism; exposure to government spending plans; 2) ESG (environmental, social, governance) strategies; and 3) digital revolution covering existing applications and emerging technologies (video games, AI, cloud, VR, cyber security, etc).’

On the other side of the argument Vanguard’s Fitzgerald thinks a 60/40 approach might prove more durable pointing out that by investing in a globally diversified portfolio of a large number of stocks and bonds you should gain exposure to businesses which are involved in the ownership and production of alternative assets like property and gold anyway.

You could consider a middle road between the two with perhaps a 60% allocation to equities, 30% to bonds and 10% in alternative assets. If you’re feeling more nervous perhaps have 5% in alternatives and 5% in cash.

INFLATION-PROTECTED PRODUCTS

Lucy Coutts, investment director at wealth manager JM Finn, believes the best way to protect a portfolio is to hold companies with lots of free cash flow and high returns on capital. ‘That was true before Covid-19 and it remains true today,’ she remarks.

‘In terms of asset allocation, I tend to have between 10% and 14% of my portfolio in index-linked gilts and US TIPS (treasury inflation-protected securities). I don’t buy TIPS directly because of the tax treatment but instead use a hedged ETF which removes currency risk.’

Coutts believes the best performing asset classes in a downturn tend to be index-linked gilts, TIPS and farmland.

‘If I’m feeling nervous, I will raise the cash level, typically I would have around 2% in cash.’ As a wealth manager, Coutts she says tends to have clients’ portfolios fully invested because she expects them to have cash reserves elsewhere. ‘If I’m feeling particularly nervous though I might move to 7% in cash – which along with around 14% in TIPS and index-linked gilts means I have 20% that isn’t equity related.’

STEER CLEAR OF INDEBTED COMPANIES AND THOSE WHICH ‘BURN’ CASH

When markets turn south, investors have a natural tendency to look for cheap stocks which haven’t been part of the bull run to use as a hiding place rather than sell out of the market completely.

However, stocks which look cheap on traditional measures such as price-to-earnings or dividend yield may be harbouring large amounts of debt which makes them much riskier than they seem at first glance.

We have previously discussed the need to avoid companies with both high levels of operational gearing – that is high fixed costs compared to their revenue – and high levels of financial gearing or debt.

When a company with high fixed costs doesn’t get enough revenue to offset its costs, high debt levels mean the problem is compounded by high costs to service the debt. Eventually the firm will fail and the debt holders will end up owning the equity while existing shareholders get nothing at all.

We suggest you screen the market to identify companies with high levels of debt compared to their equity capital and high levels of interest payments compared to the operating profits before interest costs.

Such companies represent a risk of permanent loss of capital if they end up being owned by the bondholders.

We would ignore investment trusts and financial firms including banks as customer deposits are effectively liabilities. We would also make allowances for firms with lots of leases as IFRS 16 now classifies them as debt rather than an operating cost.

As an example, pharmaceutical firm Indivior (INDV) – whose shares are up 124% year to date – would not be on our ‘safe to buy’ list.

INVESTING IN THE WEALTH PRESERVERS

Capital preservation trusts have delivered positive total returns over the ups and downs of the past 10 years, as the table shows, building on their formidable long-run performance records.

These specialist wealth preservers are not to be confused with so-called ‘absolute return’ funds. In theory the latter should protect your capital better than traditional funds or trusts given their ability to ‘short’ the market, yet many have failed to live up to their mandate of reducing downside risk during falling markets.

Capital preservation plays include RIT Capital Partners (RCP), a defensive growth portfolio boasting an exceptional record since listing on the stock market in 1988, albeit down 12.8% year to date.

Ruffer Investment Company (RICA) has fared the best among capital preservation trusts in 2020 so far. It has delivered against its objective of preserving shareholder capital regardless of the market conditions, while also eking out some much-needed growth.

Despite significant market stress and economic uncertainty, its all-weather portfolio generated a net asset value total return of 10.1% for the 12 months to 30 June 2020. Ruffer not only protected capital in the sell-off in February and March, but also managed to capture the rebound since April, posting one of its strongest three month periods ever in the second quarter of 2020.

Though its shares were hit hard in early 2020, positive portfolio contributions came from credit protection, gold, index-linked bonds and option protection.

Another master at protecting and growing investors’ money is Capital Gearing Trust (CGT), which has a good track record of holding up during market sell-offs, including during the financial crisis. The trust’s stated objectives are to preserve shareholders’ real wealth (i.e. accounting for inflation) and achieve absolute total return over the medium to longer term.

Though there could be spells where the trust sees scant growth, it also means that when there’s a market correction, shareholders’ wealth should be in safe hands.

Capital Gearing’s secret sauce is its defensive mix of assets split between equities (via other investment trusts and exchange-traded funds), index-linked government bonds, and cash and short-duration bond-like securities.

Elsewhere, Personal Assets Trust (PNL) focuses on high quality companies that generate sustainable returns over the long run. Its stated investment policy is ‘to protect and increase (in that order) the value of shareholders’ funds per share over the long term’.

Aimed squarely at the cautious investor, the wealth preserver maintains high levels of liquidity, with substantial exposure to cash, gold bullion, UK gilts and US Treasury inflation-protected securities. During a tumultuous financial year to April 2020, the fund’s net asset value per share rose 5.3%, comfortably outperforming a 19.8% fall for the FTSE All-Share Index.

We suggest you buy Personal Assets Trust.

ALTERNATIVES TO EQUITIES

A strategic approach to bonds

Historically bonds have provided investors with some protection during periods of falling share prices. This is due to central bank actions to loosen monetary policy and lower short-term interest rates during recessions. Bond prices move in the opposite direction to yields, so lower yields provide investors with capital gains.

However with UK Government bond yields negative all the way out to five years and the 10-year gilt yielding only 0.14%, the prospect for further capital gains looks slim according to fund managers at Artemis.

A better option is to look at strategic bond funds because these generally have a more flexible mandate to search out opportunities across global sovereign bonds as well as invest in corporate bonds. Effectively the risk of the portfolio can be dialled up or down according to the perceived opportunities.

One example is the Allianz Strategic Bond Fund (B06T936) managed by Mike Riddell and Kacper Brzezniak and backed up by the significant resources of Allianz Global investors, one of the largest bond managers in the world.

The managers have a clear goal to position the £1.7 billion portfolio to ensure it provides good diversification benefits. Over the last three years the fund has delivered an average annual return of 9.2% compared with 3% for the benchmark.

We suggest you buy Allianz Strategic Bond Fund.

Why you may want to buy a gold ETF rather than a gold miner

Gold has proven to be a reliable safe haven in tough times. This is often not the case in the initial stages of a sell-off when people are keen to convert to cash and gold is quite an easy thing to sell but measured over a longer timeframe it can deliver.

In the financial crisis gold actually fell initially but by 2011 had hit a new record level of $1,920 per ounce. As we write the precious metal is above $1,890 and threatening to set a new high. For the more cautious investor it makes sense to access this market through an exchange-traded fund than a gold miner in order to avoid operational, financial and geopolitical risk.

While the risk could go both ways – you could benefit if a miner grows production, for example – it is probably more important to limit your exposure to anything going wrong given you are buying gold specifically for the downside protection it offers.

There are several gold ETFs listed in London, many of which offer the added security of being backed by gold bullion stored in a vault. We suggest you buy iShares Physical Gold (SGLN).

DISCLAIMER: Editor Daniel Coatsworth owns shares in Smithson referenced in this article

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