With US stocks trading close to all-time highs, valuations looking stretched and one of the narrowest markets on record, this could be an opportune moment to consider adding some defensive qualities to your portfolio through capital preservation funds and trusts.

These products aim to protect your capital during periods of heightened volatility and equity market drawdowns as well as growing capital ahead of inflation over time.

However, strong equity market returns appear to have driven investors away from capital preservation funds leading to consistent outflows across the sector over the last three years.

Despite many managers actively buying back their own shares, valuations in the sector have drifted out to a discount to NAV (net asset value) instead of their usual premium showing how out of favour the sector has become. In this article we profile the leading capital preservation names and identify one fund which we think is worth adding to a diversified portfolio.

LOW FUTURE RETURNS

Freddie Lait, founder of Latitude Investment Management and investment manager of the Latitude Horizon Fund (BG1TMR8), believes based on current valuations the implied forward return for the S&P 500 over the next one to 10 years is between 1% and 3% per year.

Similarly, investment bank Goldman Sachs issued a report in October suggesting their base-case forecast for the S&P 500’s total return was an average of 3% per year over the next decade.

‘Our forecast would be 4 percentage points greater than our baseline if we exclude a variable for market concentration that currently ranks near the highest level in 100 years’, added the investment bank.

High market concentration is expected to lead to higher market volatility, and one of the benefits of investing in capital preservation funds is they have historically provided returns with far less volatility than the market indices.

As the charts show, these trusts have successfully protected investors capital during the biggest bear markets over the last 24 years.

HOW DO THE TRUSTS WORK?

Troy Asset Management, which manages Personal Assets Trust (PNL), says it aims to ‘protect investors’ capital and increase its value over time’.

Capital Gearing’s (CGT) manager Peter Spiller explains the trust’s primary objective is not to lose money.

‘Our portfolio is invested so investors are able to participate in some upside from the stock market and bonds but are protected from steep downturns.’

Fund Manager Duncan MacInnes at Ruffer Investment Company (RICA) says the trust focuses on keeping clients safe.

‘Over a full market cycle, we have demonstrably added a smoothing or volatility dampening effect to our investor portfolios,’ says MacIness.

Freddie Lait sees the Latitude Horizon fund’s role as providing investors a steady return over time while allowing clients to ‘get a good night’s sleep’.

DIFFERENT APPROACHES

While these principles all sound very laudable, they also sound rather similar, so the question is how do the trusts differ in terms of their approach and investment style and how they are currently positioned?

Having spoken with each of the managers, there are important differences in investment style and portfolio construction which investors may not be aware of at first glance.

Personal Assets Trust is focused on investing in high-quality businesses which can compound their earnings sustainably over time.

The team also likes companies with strong balance sheets and a competent, well-aligned management team.

Its top equity holdings include consumer goods firms Unilever (ULVR) and Nestle (NESN:SWX), software giant Microsoft (MSFT:NASDAQ) and Google owner Alphabet (GOOG:NASDAQ).

In contrast, the team at Capital Gearing takes its inspiration from the father of value investing, Benjamin Graham, and invests almost exclusively in investment trusts trading at a discount to NAV.

Latitude Horizon’s Freddie Lait is also a fan of Graham’s value approach and has built the ‘margin of safety’ principle into his investment process.

Lait looks to invest in companies which can sustainably grow earnings per share faster than the market average, which has helped the fund deliver strong returns since launching eight years ago.

Ruffer is more difficult to pin down in terms of investment style, although today it is more contrarian and value-driven.

In the past, the manager has owned the ‘Magnificent Seven’ stocks, and one of its best-performing individual equity positions was grocery retail technology group Ocado (OCDO), which it held from 250p to more than £20.

However, the trust’s exposure to Chinese and UK stocks speaks volumes about how the team view the current opportunities and risks – at a time when global managers struggle to allocate the UK even a market-neutral 3.5% weighting, Ruffer currently has 12% of the fund invested in UK equities.

As well as different philosophical approaches to investing, the investment managers construct their overall portfolios differently too.

PERSONAL ASSETS TRUST

Troy Asset Management employs the same capital preservation strategy in the closed-end vehicle Personal Assets and its open-ended equivalent the Troy Trojan Fund (BZ6CNS3).

The managers start the investment process with a focus on finding ‘high-quality companies at the right price’ and then try to diversify the portfolio with lower-risk assets such as bonds, gold, inflation-protected bonds and short-term gilts.

The amount of diversification and protection they deploy depends on the level of risk that founder and investment manager Sebastian Lyon and assistant portfolio manager Charlotte Yonge perceive there to be in capital markets at any given time.

Currently, the managers are positioned more defensively than usual because of worries over the high valuations of US stocks and rising geopolitical risks.

The proportion of the fund in equites is currently a lowly 28%, compared with an average of 43% since inception in 1994, but it is important to understand the allocation process is dynamic.

In 2008 to 2009, the equities proportion of the fund was over 70% as the managers sought to take on more equity risk during a time when markets were reeling from the global financial crisis.

CAPITAL GEARING TRUST

Capital Gearing Trust is managed by CG Asset Management, founded by Peter Spiller who has managed the trust since 1981 and remains actively engaged in the day-to-day management of the business.

The trust has a particular client profile in mind when investing – typically one with a long-term horizon, an aversion to significant short-term losses and a desire to grow their wealth ahead of inflation.

The trust has only suffered two down years since 2001 (-4% in 2022 and -2% in 2014), and has generated an annualised total NAV return of 8.3% per year, easily outpacing inflation of 2.5% a year.

These returns have been achieved with much lower volatility than the FTSE-All Share index, providing investors a smoother return.

The employee-owned firm has been built on the three core principles of ‘the client comes first, don’t be greedy, and have fun’.

A distinguishing feature of Capital Gearing is that, unlike the others in the sector, gold does not feature heavily in the portfolio as the managers prefer to use inflation-protected bonds as a hedge against inflation.

The managers expect inflation-linked bonds to continue to outperform nominal bonds as investors underestimate near-term inflation.

The portfolio is split into three distinct buckets, comprising, equities, index-linked bonds and dry powder in the form of cash and short-dated bonds.

Its current positioning is very defensive with dry powder representing around a third of the portfolio as the managers are concerned over the high valuations of US stocks.

Where the managers cannot get exposure to a market via investment trusts they use ETFs (Exchange traded funds) for exposure, with the Japanese market being a good example.

The focus on investment trusts means the portfolio is very diversified considering the number of positions it holds indirectly.

Current positions include Smithson Investment Trust (SSON) and Finsbury Growth and Income (FGT), which are trading on double-digit discounts to NAV and buying back shares.

An interesting counter-cyclical holding is Brevan Howard’s BH Macro (BHMG), which trades at a large discount to NAV.

The hedge fund has a strong track record of delivering positive returns during market downturns. During the stock market rout of 2022, the fund delivered a 20% return and the trust then traded at a premium to NAV.

Capital Gearing is competitively priced with a 0.4% management fee and 0.47% ongoing charge. 

LATITUDE HORIZON

The Latitude Horizon fund invests roughly half the portfolio in a concentrated selection of large-cap, global stocks at modest valuations, and the other half in lower-risk assets like index-linked bonds, gold, currencies and cash.

This means the fund looks to embrace volatility at the individual stock level while endeavouring to reduce it at the portfolio level.

Lait deploys a rigorous investment process and takes a genuine long-term approach to unearthing companies he believes can sustainably grow earnings per share at double-digit rates yet are trading at a discount to his estimate of intrinsic value.

This discount provides a margin of safety against unforeseen events and can reduce volatility during market drawdowns, a strategy which proved particularly effective in 2022 when stock markets fell in response to aggressive interest rate increases by central banks to combat inflation.

Since inception, the equity portfolio has grown at an average compound annual growth rate of around 14% per year, which is in line with the growth of the intrinsic value of the companies in the portfolio supporting Lait’s view that share prices follow earnings over the medium term.

Top equity holdings include credit card company Visa (V:NYSE) , UK grocer Tesco (TSCO), US auto parts and accessories retailer AutoZone (AZO:NYSE) and investment firm Bank of America (BOA:NYSE).

The top 10 holdings represent a quarter of the overall value of the equity portfolio, while long-dated inflation-linked bonds are 10% of the portfolio and shorter-dated gilts and bonds make up the rest, which reduces the equity risk while paying a steady income of just over 5% at current prices.

Bonds also have the potential to perform well when equity market fall as investors rush into safer assets.  

In his latest investment commentary Lait notes: ‘We are still fearful of the market more broadly which implicitly assumes that Goldilocks is here to stay, and inflation will not return.’

It is worth noting the Horizon Fund has bucked the trend of outflows in the capital preservation sector, with inflows equivalent to 47% of NAV over the last three years reflecting the fact it has outperformed its peers since its launch eight years ago.

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RUFFER INVESTMENT COMPANY

Ruffer is different to the other capital preservation vehicles in that it actively uses derivatives to manage risk and it has, in the past, successfully invested in bitcoin.

Investment manager Duncan MacInnes told Shares that to achieve its long-term objectives the team thinks differently about risk.

‘We start our investment process from the perspective of risk minimisation. We believe the key to long-term sustainable returns is avoiding the points of material capital loss in financial markets. If you avoid the drawdowns – the upside looks after itself,’ explains MacInnes.

While other managers build the portfolio they want, then try to add hedges to protect against the downside, Ruffer starts by seeking capital protection first.

The trust offers retail investors access to some strategies they might not be able to do directly themselves, particularly derivative protection or more non-traditional assets like commodities or the Japanese Yen.  

The investment team is led by Henry Maxey and Neil McLeish, who act as co-chief investment officers, supported by an asset allocation team of senior fund managers and partners, such as MacInnes, alongside chairman Jonathan Ruffer.

MacInnes points out that very few other firms made money in each of the past bear markets, including the dotcom bust, the credit crisis, the covid crash and market fall of 2022.

Similarly, very few firms made money in both 2008 and 2009, which demonstrates the value of having the ability and the conviction to pivot from bearishness to bullishness when the circumstances change.

Ruffer invests across a wide range of securities including stocks, bonds, currencies and commodities as well as a small allocation to derivatives.

MacInnes says most of the trust’s returns have come from asset allocation to the most liquid markets in the world.

Often, outperformance derives from not owning particular assets. Examples include not owning dot-com stocks in 2000, not owning banks, commodity, or property stocks in 2008 and not owning profitless tech companies in 2022.

In terms of the investment outlook, Ruffer believes recent events including the Trump victory strengthen the case for a second wave of inflation.

While the market seems convinced of a soft landing, Ruffer sees an opportunity to take the other side of the trade believing US equities and credit spreads look unfavourable from a risk to reward perspective, with high valuations and ‘extended’ positioning.

Therefore, the company owns a combination of downside protection via equity index put options (bets that prices fall) whilst holding a ‘significant’ proportion of the portfolio in cash assets yielding between 4% and 5%.

In addition, the company has assembled a collection of assets where bad news is perceived to be already priced in such as commodities and cheap equity markets such as the UK and China.

This so-called ‘ugly duckling’ portfolio showed its mettle over the summer, demonstrating the potential of the portfolio to deliver powerful returns, says McInnes.

Near-term, the company’s positioning differs from the other vehicles in the space as the portfolio balance has been adjusted to reflect an increase in risk appetite following the ‘market-friendly’ outcome of the US elections.

Net equity exposure is around 40% with a further 10% allocated to commodities and precious metals, which represents the highest allocation to risk assets since early 2022.

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