The past few months have been a turbulent time for the markets. The Chinese stock market bubble has burst, reinforcing fears about the health of China’s economic model and what that might mean for global growth. More recently, the decision by the US Federal Reserve to hold back on raising interest rates in September as it had previously guided, has fuelled global pessimism over the prospects for global growth and fragility of the financial system.
So where should investors turn in rocky times for equity markets? Options for cautious investors might range from fixed income, targeted absolute return funds, multi-asset funds and convertible bonds. But it is also the case that some equity fund managers have more defensive investment styles than others.
At Tilney Bestinvest, we have just produced research highlighting the equity fund managers who have demonstrated a high incidence of protecting their portfolios in months when the markets have fallen across their careers. The research looked at the track records of 353 fund managers or teams with tenure in a sector of at least five years in a particular sector*. View the funds research highlights here.
So, what were the findings?
Active equity fund managers have a much higher relative success rate in down months than up months. We found that on average 79% of active fund managers had outperformed their respective index most of the time during months when the markets fell while on average only one third of them outperformed most of the time in months when the markets they operate in rose. This is of course in part down to the fact that few managers are fully-invested at any given time as cash is coming in and out of the fund, so this liquidity provides a buffer in tough times and a drag factor in a strongly rising market.
Yet it is also the case that managers will proactively, as opposed to inadvertently, use cash positions in tough times, and can take defensive positions. For example, in recent times many active UK equity managers have been avoiding commodity stocks and companies with high exposure to China and emerging markets, which we believe is one of the major factors that has resulted in the vast majority of active UK equity funds outpacing the returns of index trackers over one, three and five years. The latter have been fully exposed to under pressure mining and oil and gas stocks.
Who are the most defensive managers?
A notable example of a manager prepared to tactically allocate to cash is JO Hambro Capital Management’s John Wood who we calculate has beaten the market 77% of the time during down months over an identifiable career spanning more than 13-years running funds in the UK All Companies sector at Newton and latterly JO Hambro. Wood has been warning for some time about the risk of a “financial tsunami” and accordingly positioning his fund very defensively. At the end of August the fund was weighted 17.6% in cash.
A different approach has worked successfully for duo Anthony Cross and Julian Fosh who co-manage the Liontrust Special Situations, UK Growth and UK Smaller Companies funds. The team feature in our research as having successful defensive track records in down markets in both the UK All Companies and UK Smaller Companies sectors. Their investment philosophy, which they called the Economic Advantage process, is to focus on companies that have a durable economic advantage that provides resilient performance throughout the ups and downs of the economic cycle. This might include ownership of intellectual property, such as patents, strong distribution channels that are difficult for competitors to replicate and a high degree of recurring earnings versus transactional activity. The approach has clearly been successful with very consistent outperformance and a strong record for capital preservation in tough markets, but investors should remember that past performance is not an indicator of future returns.
With markets having sold off aggressively in recent months, investors face the conundrum of deciding whether to add to their portfolios while markets are weak while also being mindful about the potential for further volatility in the near term. Investing with managers with strong defensive qualities might prove a sensible way to access the markets.
* For the purposes of analysing manager career records and evaluating the success of investment decisions we have stripped out the impact of fund costs. Where a manager has run more than one fund with the same sector at the same time, we have blended the track record.
Tables of most defensive equity fund managers
UK All Companies
UK Equity Income
UK Smaller Companies
Europe Excluding UK
Asia Pacific Excluding Japan