Asset allocation: Brooks Macdonald’s Gumpel on the defensive

Brooks Macdonald co-manager Jon Gumpel’s first priority is playing it safe amidst market uncertainty.

His £194m Defensive Capital Fund, which he runs with Robin Eggar, aims to provide the stability of bonds while maintaining exposure to potential equity upsides.

The adjective “defensive” on the fund is to give investors a clue of what the team was looking for, says Gumpel, who has been managing the fund since its launch in December 2006.

He looks at attractive capital returns from defensive assets such as zero dividend preference shares, structured products, convertible bonds and discounted assets.

However, Gumpel thinks defensive assets have limits.

A key problem with these more cautious assets is that so many are priced off government bonds, meaning they are at extremely low yields and “may well be in a bubble”.

“It is a case of just simply positioning yourself for the right investment that would give you the right returns over 12 to 36 months, so the way that we try to protect ourselves is to buy relatively short-dated investments,” he says.

Due to the structure of preference shares, the fund has security over 3.1 times its total assets, making it a robust protector of capital.

Gumpel explains: “The average term to maturity of the fund is 3.1 years, meaning that in the event the market falls 30 per cent our cover will fall form 3.1 times to 2.1 times so we will still be 2 times covered because we’ve got that high level of cover.”

The fund offers more certain returns than equities and bonds which are both highly valued, Gumpel adds. He does not favour the equity market generally because it is “over-extended”.

He says: “There is a lot of complacency in the equities and bond markets at the moment. I don’t like the rising volatility so I think this is a period of time to take a little bit of protection and that’s what we are looking to do.”

The uncertainty around any interest rate move by the US Federal Reserve is also leading Gumpel to be more defensive.

“We don’t know if the US will decide to raise rates or hold them to zero. They’d love to get out of that zero interest rate policy but they are terrified of doing that. It should happen this year but I think the longer it goes on the more it damages the long-term economy and economic markets.

“The real danger for the world is if the US feels that the downsides of a zero interest rates policy are more dangerous than the cost and danger to markets of getting rid of it.”

The uncertainty around rate rises and changeable environment generally mean Gumpel has also reduced the fund’s equity exposure, which he accesses via derivatives.

He says: “Equity exposures to the US equities and FTSE 100 went down from 9.5 per cent in November to 4.4 per cent in May in the derivative structures, which give us the cleanest and cheapest exposure to indices on an accelerated basis.”

He has reduced US equities from 0.6 per cent to zero as they are “too expensive”, and UK equities from 4.5 per cent to 0.6 per cent before the general election because the team was cautious of a Labour and SNP victory.

On the UK Gumpel is “less negative but certainly not positive” in the short-term, believing “the post-election strength is a strength to sell into”.

The team then reallocated that US and UK exposure to Japan and Asia (2.6 per cent) and Europe (1.2 per cent).

Gumpel is also waiting for an opportunity to increase weighting in Japan “over time”.

Japanese companies have good prospects and by comparison companies in the US face almost the reverse of conditions in Japan, namely loss of sales and earnings momentum, higher gearing, a strong currency and an increasingly less supportive central bank.

With equities not being the favourite asset class for Gumpel, he looks into asset-backed bonds for better returns.

“We also bought asset-backed bonds, which offer attractive returns. There were banks forced out the market by newer and more competitive and technologically advanced lenders, banks had to reduce their balance sheets, and that has created attractive investment opportunities for funds like us,” Gumpel adds.

He also favours RMBS (residential mortgages backed securities), which still have “a lot of post crisis value” and a decent level of yield “you cannot find with similar risk adjusted returns elsewhere”.

The fund, which is currently in the IA Mixed Investment 20%-60% Shares sector, is soon to move to the IA Targeted Absolute Return sector, which is “a much more natural home” for it.

“The reason we changed is because the beta of the fund is much closer to the beta of the absolute returns sector than it is to the IA Mixed Investment 20%-60%. Our volatility is much closer to that,” he says.

Moving ahead, Gumpel believes the fund is well positioned for continued good performance, despite market volatility.

The fund is on track to return 7 to 8 per cent a year, “as long as the S&P 500 and other equity markets don’t fall by more than 40 per cent,” he says.

“While we are cautious in the short term we think there are attractive returns to take from the market going forward.”