Adviser workshop: how to create downside protection in portfolios

The era of volatility has well and truly returned. Here's the expert view on how to handle it

The past few months have proved a nightmare for investment markets, with both bond prices and equity values falling sharply. With such a large downswing, particularly in US equities at the end of 2018, the era of volatility has well and truly returned.

How do IFAs manage this, and how do they include downside protection in their portfolios? Many advisers will steer away from funds with downside protection built in, and will focus on ensuring their clients are properly educated about downturns. The aim is to avoid clients panicking when markets go south.

However, for those who do seek some form of investment protection, there is a range of options available, from absolute return funds using derivatives, to smoothed funds such as Prudential's PruFunds.

Navigating this maze of products is a complex task, particularly as they often do not come cheap. Here, we take a look at some of the best ways IFAs can incorporate downside protection.

The past few months have proved a nightmare for investment markets, with both bond prices and equity values falling sharply. With such a large downswing, particularly in US equities at the end of 2018, the era of volatility has well and truly returned.

How do IFAs manage this, and how do they include downside protection in their portfolios? Many advisers will steer away from funds with downside protection built in, and will focus on ensuring their clients are properly educated about downturns. The aim is to avoid clients panicking when markets go south.

However, for those who do seek some form of investment protection, there is a range of options available, from absolute return funds using derivatives, to smoothed funds such as Prudential's PruFunds.

Navigating this maze of products is a complex task, particularly as they often do not come cheap. Here, we take a look at some of the best ways IFAs can incorporate downside protection.

The Adviser View

Charles says...

Over the past couple of years, we have put more money into the absolute return sector, taking advantage of the downside protection it can provide through hedging and short positions. We also have a bit of an equity income focus. If markets are turbulent, a dividend yield is always helpful in mitigating some of the volatility.

The absolute return funds have become an alternative to bonds. Bonds were quite aggressively priced, and we felt they were no longer the lower-risk option they once were.

We would potentially use short-dated bonds, but nothing more. The prices went up so strongly off the back of quantitative easing, that in a rising interest rate world and with the pull-back of quantitative easing, we do not think these bond prices are likely to be maintained.

In the past we have used JP Morgan's JPM Global Macro Opportunities fund and paired it with the slightly less volatile Janus Henderson UK Absolute Return fund. We try to use both. We met the fund managers of the JP Morgan fund towards the end of last year. They have taken a big short position on the US market, which has hopefully borne some fruit over the past few months.

For specifically reducing risk, cash is an obvious and easy option that is sometimes overlooked. Putting a proportion in cash is a simple way of taking risk off the table. You know you are not going to a get a return on it, but in the event of significant downside, cash will hold up.

Apart from that, we talk to clients and emphasise the importance of time frames and looking through any short-term shocks in the markets. Client goals are the most important thing.

Charles Chami is director at Glamis IFA

@Charlie_IFA

The Consultant View

It is really difficult for advisers to incorporate downside protection, because the assets they would traditionally use for this type of protection – high-grade corporate bonds – have started behaving like large-cap equities.

So, advisers either have to go down the quality spectrum for bonds, or further down the risk spectrum to cash. Once you do that, you are effectively sacrificing potential upside for downside protection.

Absolute return funds, while they may look convenient on the surface, are not necessarily the answer. And buying derivatives is an expensive and highly complex game. Advisers therefore cannot realistically provide downside protection, other than moving into cash at the right time.

All they can do is aim to limit volatility, which is not the same, and take a long-term view with clients. It is fine if the client’s situation allows it, but if the client has a shorter-term horizon, it becomes much more challenging.

In a bull market, smooth managed funds such as PruFunds, Aviva Smoothed Managed and potentially Standard Life’s Global Absolute Return Strategies, appear to have done a good job of dampening volatility. They could theoretically provide some protection, particularly by using alternative assets such as infrastructure. However, many of them have not yet been tested in a genuinely adverse market.

This could be an area in which, if the client is wealthy enough, the use of directly held alternative assets becomes more interesting for advisers than it has in the past. For example, renewables, or some of the assets you might find inside enterprise investment schemes and venture capital trusts. These are risky in their own way, but may behave differently to some of the more mainstream assets.

These assets have been the preserve of wealth managers and tend not to be used by IFAs. But lines could start to blur as we get into more trying economic circumstances.

People are desperately trying to find options that are not correlated with large-cap equities, and probably the need for sustainable power and the reduction of air pollution.

Mark Polson is principal at the Lang Cat

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