As with umbrellas, defensive investments only really help if they are in hand before the deluge.
A joint US-Israeli attack on Iran has brought that type of storm to world markets this month. Market volatility has soared as the risk of inflation, primarily from higher energy prices, has once again returned.
After repeated bouts of market turmoil due to the actions of President Donald Trump, building a defensive Isa for just such occasions increasingly makes sense: one can take income from this tax shelter while also preserving capital. Meanwhile, the easiest means of protecting one’s funds, the cash Isa, will have its annual limit reduced from £20,000 to £12,000 from April next year.
In November, UK chancellor Rachel Reeves announced the change, though she made an exception for those over 65. Reeves has been keen to encourage more savers to put their cash into investments, in an attempt to generate higher returns for individuals and potentially funnel more money into UK stocks.
She wants to push those types of savers out of their comfort zone, not to mention recover some of the tax revenue lost to cash Isas. Unfortunately, that also means impelling them into some of the choppiest markets since the pandemic.
Certainly, the gilt market’s UK inflation expectations for the next two years have climbed this year. At nearly 4 per cent, they hover at the high end of the five-year range.
For cautious investors, building a stocks and shares Isa that earns an inflation-beating return with protection against gut-wrenching market volatility at a reasonable cost should offer the holy grail of portfolios.
Building a defensive Isa will require some self-reflection on the investment returns you desire, versus the amount of risk you can tolerate. A 5 to 10 per cent annual return may beat inflation, but what happens when all markets — stocks and bonds — drop? That occurred in 2022 and could happen this year.
What kind of decline, or drawdown, can you tolerate? That depends on when you might need that money, of course. Big drawdowns that arrive just when you want those funds will mean liquidating your holdings into weakness, the worst time.
Assuming that capital stability is a primary goal, start with a safe, cornerstone investment (around 10-20 per cent of the portfolio). Having some of your Isa allowance in a sterling money market account provides a good start. “Money market funds are designed to be low-risk products that behave in a cash-like manner,” says Kyle Caldwell, funds expert at investment platform Interactive Investor.
“Investors often use them to park cash balances for a short period while deciding where to invest, or as a ‘shelter’ during periods of stock market volatility.” Their yields tend to track shifts in inflation expectations faster than bank deposit rates. He recommends Royal London Short Term Money Market, a popular money market fund, which was yielding 4.25 per cent at the end of February.
These money market funds should only occupy the very conservative end of a defensive portfolio. Even a cautious investor will need at least some riskier holdings. But this doesn’t necessarily require anything complicated. There are funds that offer some sort of multi-asset approach, with low to very low amounts of riskier assets such as equities, which over longer periods tend to outpace inflation.
The “wealth preservation” trusts which have consistently delivered in terms of protecting capital during periods of stock market weakness include Capital Gearing, Personal Assets and Ruffer Investment Company. Each has a low weighting to shares and plenty of defensive holdings, such as low-risk inflation-linked bonds, but they take different approaches to each asset class. These funds are available as listed investment trusts, offering decent trading liquidity.
All of the funds have easily outpaced inflation over a decade or more. However, their five-year records to early March are mixed. Personal Assets performed best with over 5 per cent annualised total returns, according to Bloomberg. Ruffer and Capital Gearing each returned about 3 per cent.
“We go for long periods when we are overlooked by investors,” says Charlotte Yonge at Troy Asset Management, which runs the Personal Assets Trust. “In moments of sell-off we are the part of people’s portfolio that doesn’t draw down.”
She reckons it offers a “sleep well” investment, as opposed to the riskier “eat well” version. The trust currently holds about 39 per cent of its portfolio in high-quality companies, some of which were bought in the market wipeout following the US tariffs announcement last April. Along with over a quarter of the portfolio held in short-dated inflation-protected US and UK government bonds, Personal Assets has 10 per cent in physical gold bars.
Ruffer Investment Company also owns gold and precious metals, with a roughly 5 per cent allocation. It differs from Personal Assets Trust by holding a much bigger proportion in more typical short-dated nominal bonds — 42 per cent — and much less than that separately in index-linked bonds.
The Ruffer fund uses derivatives, in both credit and equity markets, to hedge the portfolio against wider market risks.
“In our view, we are living through a period of ‘regime change’,” says Jasmine Yeo, the co-manager of Ruffer Investment Company. This period will be characterised by higher, more volatile inflation, elevated geopolitical tension and an unsustainable rise in government borrowing, she adds.
Capital Gearing Trust has the most conservative approach of these three, and may be best for those worried about inflation but who don’t see any urgency to own a lot of gold. Nearly half of the portfolio sits in index-linked government bonds and another 29 per cent in other bonds and corporate credit.
That understandably leaves little room for riskier equities, which for CG are usually investment trusts trading cheaply below their net asset values.
Even then, Emma Moriarty, portfolio manager at CG Asset Management, says she has concerns that the high valuations she sees in the US stock market could quickly translate into falls in all UK shares, including trusts. The portfolio’s equity portion at 24 per cent is at its lowest ebb since 2012.
Notably, Moriarty’s fund owns very little gold, only about 1 per cent in physical gold exchange-traded funds. While admitting that the fund has missed out on the sharp rally over the past couple of years, she argues that “we think the value of it looks very speculative at this point, much like US equities”.
Given its focus on low-risk yield investments, CG’s performance has held rock solid in difficult periods, such as the current one. Indeed, since the Iranian conflict began on February 28, these three funds have held up well relative to both equities and bonds.
All are either down only a small amount or, in the case of the Ruffer share price, up by about 1 per cent. Note that each actively manages any trust discounts or premiums by purchasing or selling shares as needed.
This brings us back to the tricky area of return expectations for our putative defensive Isa owner. However low the risk appears, the prospect of mid-single-digit returns over the medium term will hardly set pulses racing, even in a tax-sheltered Isa.
These low-return funds may not provide enough return for some investors, who will be looking for a bit more growth in a defensive Isa, without taking excessive risk. This can be done by introducing conservative, actively managed equity funds into the defensive Isa.
The point is that one need not settle for cash-like returns in order to have a defensive Isa. Not surprisingly, adding some growth by using City of London Investment Trust, up 13 per cent annually over five years and well ahead of the All Share Index, would have perked up a portfolio made up of the wealth preservation trusts and money market funds. The latter have only delivered low single-digit gains over the past five years, sometimes trailing inflation.
Yet assuming that we have moved into a new era, where price volatility persists and inflation remains a problem, the appeal of defensive investing, especially using tax-efficient Isas, will also linger. Coupled with a wedge of money market funds for liquidity, a multi-asset approach with some combination of inflation-protected bonds and absolute return funds may offer the best choice going forward.
RIT Capital, part of J Rothschild Capital Management, does have both direct private capital holdings, including SpaceX, as well as ownership of private equity and hedge funds. Its aim is to allocate to uncorrelated strategies. Although performance has been lacklustre in the past five years, under 1 per cent, the strategy does make some sense in a world of volatility and rising inflation.
In recent years, various sectors or even investment styles, such as quality or value, have offered safe havens. But, as these trends can change quickly, someone building their own defensive Isa might choose to use portfolio managers.
Personal Asset, Capital Gearing, RIT and Ruffer have fees at 1 per cent or less, with few if any additional costs, with RIT and Ruffer the pricier choices. The City of London trust has very low fees, under a third of 1 per cent.
If inflation becomes a problem, cash won’t offer much of a solution. Yes, a cash Isa is a boon for higher earners. Those seeking a defensive strategy for their portfolios should look at other opportunities. Wrapping these up in a defensive Isa would make more sense than simply holding it all in cash. A mix of inflation-protected assets will prepare you better for any heavy weather ahead.