On the edge

Demand climbs for funds in the Cautious Managed sector, despite mixed performance and susceptibility to market wobbles. Will Jackson examines the aim of the sector and its frayed image as a low-risk haven.

Demand for Cautious Managed funds is booming. According to the Investment Management Association (IMA), the sector achieved higher net retail sales than any other during the second quarter of 2010. Cofunds, which claims a 17% share of the British platform market, reports a similar trend. Gross Cautious Managed fund sales edged over the £100m mark for the first time in March this year, and the sector accounts for about 20% of the platform’s monthly inflows since the middle of 2009.

As the Cautious Managed name suggests, funds within the sector are marketed as low-risk propositions – a concept that appeals to investors weary from extraordinary market volatility over the past decade. But the poor performance of some products during the banking crisis of 2008 led some commentators to question the value of the sector. So, with money once again streaming in, have managers learnt their lesson? And should the peer group be redefined to better protect investors?

The sector can trace its roots to the Managed Fund category, created by the Association of Unit Trusts and Investment Funds (Autif) in 1998. According to Philip Warland, the association’s director general, in January of that year, the peer group was founded as “an ideal first base for new investors” and to satisfy growing demand for asset class diversification. “Unit trusts overall are designed to spread risk, but our managed funds must be even more broadly spread than most,” Warland wrote. (article continues below)

To ensure the sector offered a sufficiently varied selection of assets, Autif imposed several minimum requirements. The 36 portfolios that joined the sector at launch were obliged to hold at least: three asset classes (with a minimum of 50% denominated in sterling, or hedged to sterling), 35% in British equities, and 10% in overseas shares. In addition, managers were required to invest a balance of 10% or more in British gilts or bonds, non-British government bonds, corporate bonds, cash or property.

”Cautious Managed is the classic sector where you put your retirement money and it should not lose a lot of your capital”

A year later, however, the association’s Performance Category Review Committee overhauled its classification system, and divided the Managed Funds sector into Active, Balanced, Cautious and Income categories. Cautious Managed funds were restricted to a maximum of 60% in equities and a minimum of 50% in sterling/euro-denominated assets. The definition was later tweaked by the IMA – Autif’s successor – to introduce a minimum allocation of 30% to fixed income and cash combined.

Cautious Managed has been a success story for the fund industry. Assets in the sector grew rapidly, from just £300m in January 2000 to £3 billion by the middle of last decade, and to over £15 billion by the start of 2010. Managers have capitalised on investor demand with a raft of launches. IMA data shows that there were 40 funds in the sector at the end of 2002. That number more than doubled by 2006, and by the end of 2009 investors were able to access 165 different products.

Mike Parsons, the head of UK retail sales at JP Morgan Asset Management (JPMAM), says the sector gained traction in 2001. “A lot of that was money being recycled out of with-profits funds, and Cautious Managed funds are seen as a modern proxy for [them],” he says. “When markets were running ahead in 2005, 2006 and 2007, demand for Cautious was still strong but it was masked by strong equity flows. The 10-year history is that there is more money going into the Cautious sector.”

The longer-term growth story has been bolstered over the past 12 months by investor risk aversion following the stockmarket falls of late 2008 and early 2009, and by the continuation of low interest rates on bank and building society deposit accounts, Parsons adds. His view is backed up by a survey from Fair Investment, an online financial services provider, which last week found that two-thirds of savers would not consider investing in cash while the Bank of England base rate remains at 0.5%.

Earlier this month, Roberto Demartini, an analyst at Standard & Poor’s (S&P) Fund Services, published a review of “asset allocation” portfolios – a category that includes products from the IMA Cautious Managed sector. He agrees with Parsons that investors usually regard Cautious Managed portfolios as a first step out of cash – in line with Warland’s vision for the Managed Funds sector, 12 years ago.

“Cautious Managed is the classic sector where you put your retirement money and it should not lose a lot of your capital,” Demartini says. “If you go back a few years, fund houses launched distribution funds, and they are part of the Cautious Managed sector, with the idea of giving you some income and preserving your capital. They are a tool to smooth market volatility. A lot of funds are benchmarked against inflation – they protect your purchasing power and give you some income on top”.

The oldest fund in the peer group, according to Financial Express, is Aviva Investors’ Distribution portfolio – an £80m Oeic unveiled in 1974. The fund aims to “provide a high and growing level of income with prospects for long-term capital appreciation” by investing in fixed income securities and high-yielding equities. Aviva Investors figures show the fund had a distribution yield of 5.1% at the end of June, with British bonds and stocks forming about two-thirds of the portfolio.

”A lot of funds are benchmarked against inflation -they protect your purchasing power and give you some income on top”

But despite Cautious Managed funds’ aim of providing a higher-yielding alternative to cash, investors saw some products fall sharply in the final quarter of 2008 and early 2009, before rebounding. Lipper data shows that the average Cautious Managed fund declined by 16% during 2008, with volatility (as measured by standard deviation) of 0.47.

In comparison, the FTSE All-Share index fell by 30% and registered volatility of 2.23. The sector displayed a similar relationship with the index in 2009, making about half the gains recorded by the stockmarket, with one-fifth of the volatility.

While the headline figures suggest the sector provided a good degree of protection from the market turbulence, they mask significant volatility from certain funds. Financial Express data shows that (of the funds with 2008 and 2009 figures), half of the 20 worst-performing Cautious Managed products in 2008 were among the 20 best-performing products in 2009 – implying that managers punished for carrying too much risk into the banking crisis did not take action to moderate their volatility.

The largest swing was registered by Henderson Managed Distribution, which fell 37% in 2008 and gained 44% in 2009, underperforming and outperforming the FTSE All-Share by eight and 14 percentage points respectively. The portfolio was launched by New Star, and absorbed into the Henderson range during the merger of the firms in 2009. Trevor Green, the only member of the original New Star team still running the fund, has worked with Jenna Barnard and John Pattullo since April 2009.

Barnard and Pattullo are responsible for the fund’s bond exposure, while Green manages its equity portion. Barnard and Green say underperformance in late 2008 was mostly driven by the fixed income side, as risk assets fell out of favour in dramatic style. “Too much risk was taken on,” Green says. “There was a manager who had a contrarian view, James [Gledhill], on where markets and economies were going. The fund was hurt accordingly – there wasn’t enough safety in the portfolio.”

Barnard notes that Green’s predecessor on the equity allocation also “had a tough time” in 2007 and 2008, but agrees that the main culprit was a high level of credit risk and not enough exposure to government bonds. As for the fund’s performance in 2009, Green’s portfolio benefited from an allocation to stocks in the FTSE 250 index, while Barnard and Pattullo expressed an upbeat outlook in the bond allocation.

“We were positive on risk assets and the credit market in particular [in 2009], and that chimed with what we were doing in our other funds,” Barnard says. “So the bounceback reflects the beta that it had on the way down, and that was the overriding decision we had to make in April last year – whether to maintain the beta or tone it down. We’ve had a preference for high yield bonds in this fund, and financial bonds, and those riskier parts of the credit market performed exceptionally well.”

Another product that underperformed the market in 2008 and recovered strongly in 2009 – although to a lesser extent than the Henderson fund – was Aberdeen Multi-Manager Multi Asset Distribution, a £30m fund of funds run by Aberdeen’s multi-manager team. The group, which transferred to Aberdeen from Credit Suisse last year, is led by Graham Duce and Aidan Kearney. Duce says the portfolio was hurt most by its exposure to leveraged loans, which contributed to a fall of 15% in October 2008.

“The ideology of the fund was to derive an attractive yield – we certainly have no yield target, we felt that was a dangerous thing to do – but we were typically looking to deliver something in the region of around 5% gross yield,” Duce explains. “The key to this was diversification, so we introduced other asset classes. We had exposure to the Henderson secured loans fund – at the time we had just under 5% exposure. We also had the M&G leveraged loans fund, which was some way below 2%.

“Anything to do with the word ’leveraged’ got absolutely battered. One of our reasons for investing in loans, and indeed leveraged loans, was that previously the volatility of yield spreads was extremely low. What we didn’t appreciate was the liquidity of that market when the conditions changed dramatically.” Returns were also hit by an investment in a fund of hedge funds with “a small percentage in Madoff”, he adds, as well as exposure to closed-ended property vehicles and a structured product.

”We came across funds that were invested in private equity and property, and they did not perform well at all”

As with Henderson Managed Distribution, last year’s performance, which saw the Aberdeen fund gain 22%, the 13th-largest return in the sector, was aided by the managers’ decision to ­maintain their asset allocation. Duce and Kearney sold their stake in the Henderson loans fund but kept most of their holdings (earlier this month, the fund contained 15 of the positions it held in 2008). Cash reserves of over 20% were also deployed after March 2009 to boost the fund’s exposure to “quality credit” and British equities – allowing it to benefit from last year’s stockmarket rally.

In addition to the large swings suffered by certain funds, there was also a wide dispersion of returns between products in the Cautious Managed sector. Performance in 2008 ranged from Henderson Managed Distribution’s 37% decline to a rise of 21% from Ruffer Total Return (although it should be noted that Ruffer’s record was a statistical outlier – the next-best return was 3%, and only four funds avoided a fall). Returns in 2009 varied from Henderson’s stockmarket-beating 44% to a decline of 4% from the Elite LJ Cautious Managed portfolio – the only fund to fall in value.

S&P’s Demartini says the increasingly differentiated strategies employed by Cautious Managed portfolios make meaningful comparisons between funds in the sector difficult, if not impossible. Some products, such as Gartmore Cautious Managed – which he describes as “a bog standard UK equities and UK-denominated bonds fund” – have kept their original British bias, while others, including the Jupiter Merlin Income portfolio, employ a global approach and are subject to currency risk.

Demartini also highlights the “new generation” of cautious multi-asset funds, which are able to access a diverse array of alternative asset types. Additions to the genre in 2010 included Armstrong Investment Managers’ IM Diversified Real Return fund and Heartwood Wealth Management’s Cautious Income Multi Asset portfolio. Diversified Real Return was exposed to a range of asset classes in July, including absolute return funds, equities, bonds, currencies, property and commodities.

While Demartini is broadly upbeat on asset diversification, he notes that the strategy offers limited protection when market liquidity dries up. “In times of crisis, when correlations converge to one, having exposure to property, or derivatives, or alternatives does not help,” he says. “We came across funds that were invested in private equity and property, and they did not perform well at all [in 2008].” Multi-asset investors were also hit by a double layer of fees, Demartini adds, as many products invest in other funds.

In addition to differences in geographical and asset class allocation, some funds in the sector use derivatives and others have internal rules on equity exposure. Henderson Managed Distribution and JPMAM Cautious Total Return, for example, have self-imposed limits of 40% on their stockmarket exposure. “It was a new sector to John and I when we picked it up in April last year and we found it incredibly diverse,” says Barnard. “The strategies employed by the managers vary enormously.”

Even managers who operate to the full extent of the IMA rules question whether a 60% equity limit is appropriate. Aberdeen Multi-Manager Multi Asset Distribution had a 53% allocation to stocks earlier this month. “Sixty percent for a Cautious Managed fund does seem on the high side when you compare it with other parts of the world,” says Duce. “This bias towards the equity component is very much a British thing when you look at investment traits [in] Europe.” Similar criticisms could be levelled at the Balanced Managed sector, he adds, which allows 85% in equities.

The diversity of strategies and risk levels in the peer group has led commentators to question the wisdom of grouping products under the Cautious Managed banner. Demartini says a key problem is the sector’s name, which could imply more safety than the funds can offer. “It is not the best name,” he adds. “It goes back to the fact that there needs to be some sort of a rethink on what goes into the Cautious Managed sector, because there are a lot of funds in there that are not very cautious.”

As Fund Strategy revealed last week, the IMA has begun a wide-ranging review of its sector classification system. The review was prompted by the rapid expansion of Ucits III investment powers in retail funds over the past few years, and discussions will centre on whether traditional funds which hold physical assets should be grouped with those that “gain exposure by other means”. Possible solutions mooted by the IMA include the creation of new sectors and a risk-based classification approach.

Jane Lowe, the association’s director of markets, says the review is a “long-term project” but the Cautious Managed sector will come under its scope. “Part of that discussion will relate to the managed sectors because they’re not as asset-driven as many of our other sectors, although there are some asset limits in the definitions,” she says. “So it’s inevitable that they will form part of the wider discussion [on whether the sectors should] embrace alternative strategies and other investment approaches.”

Lowe notes that concerns over the naming conventions of the managed sectors have cropped up more frequently, and says the Cautious Managed label may be reviewed. Limits on asset allocation will also be discussed. However, the IMA is likely to keep its sectors “big and beefy” rather than “chopping them into endless small groups”, she says, and the onus is on fund buyers to do their homework.

”If you look at what happened in 2008 it was one story and then in 2009 it was the complete opposite – taking a lot of risk was rewarded very well”

“[The aim of the sectors is] to give somebody a reasonable number of funds to do research on, and decide which works for them,” Lowe says. “To that extent, naming does matter, which is why we’d be quite happy to look at it again. But I think that to nail everything on the name is avoiding – or attempting to avoid – that you need to do research on the funds. I’d say quite strongly that anybody who gets no further than the label of the sector is not really understanding the sector proposition.”

Despite his view that the sector’s equity limit is too high, JPMAM’s Parsons echoes Lowe’s sentiments. “In a rising market you’d expect the funds with the most equities to be the strongest performers, but by definition [Cautious Managed] investors are more worried about the drawdown than the upside,” he says. “IFAs need to not only look at the performance figures within the sectors, but also at the asset mix of the underlying fund and the potential asset mix of the underlying fund.”

Whether many managers in the sector have changed their strategies in response to the lessons of late 2008 is hard to gauge. But despite their decisions to hold asset allocation largely steady in 2009, in anticipation of a rebound, the teams at both Henderson and Aberdeen have modified their approaches. Duce says he pays closer attention to liquidity in the Aberdeen portfolio’s underlying holdings.

Henderson, meanwhile, introduced the use of derivatives on Managed Distribution earlier this year, allowing its managers the flexibility to employ interest rate futures and credit default swaps to control risk. Barnard says similar powers helped on the firm’s fixed income portfolios during the 2008 crisis. “The credit markets became so illiquid that hedging with derivatives was the best form of defence,” she explains.

“Physically selling some of those cash bonds at the bids you would have got was not appealing, but we could hedge-up by buying credit derivatives protection. That’s something we’ve given the fund the ability to do. Obviously we don’t want to do that at the moment, but we like to think if we entered a 2008-type situation again we’d be pretty quick on the trigger there.”

However, despite the measures taken by some funds to limit volatility, some commentators are sceptical on how robust the sector would be in another crisis. “I think that there probably were lessons learned,” says Demartini. “But, at the same time, if you look at what happened in 2008 it was one story and then in 2009 it was the complete opposite – taking a lot of risk was rewarded very well. I still think there will be some [funds] that will be caught out if something ­similar happens again.”