Does playing safe cut your losses? No, cautious funds performed WORSE

Risk-averse investors have seen up to a fifth of the value of their nest eggs disappear in the past year alone, leaving many at risk for a worse retirement.

So-called “prudent” or “low risk” model portfolios are sold by some of the largest investment providers, including Vanguard, Santander, NatWest and Nutmeg.

They are designed for the more nervous investors who want some exposure to the stock markets, but don’t take so much risk that it will keep them awake at night. They are also often used by older savers who don’t want to take big risks with their money leading up to retirement.

But some of these portfolios have seen dramatic volatility in recent months. In many cases, these investments have suffered greater losses than even the riskiest or most adventurous portfolios.

Financial experts question whether these portfolios are fit for purpose or have proven to be anything but low risk.

For example, a saver who invested £1,000 a year ago in Santander’s lowest-risk model portfolio, Multi-Index Fund 1, would be sitting at £820 today. With inflation at 10.1 percent, the purchasing power of this investment would now be worth around £737. By comparison, £1,000 in Santander’s highest-risk model portfolio, Multi-Index Fund 4, would have fallen to £899 – significantly less.

A £1,000 investment in Vanguard LifeStrategy 20, one of the most popular low-risk portfolios, would now be worth around £835. Due to the ravages of inflation, purchasing power would be just £750. In comparison, £1,000 in the highest risk LifeStrategy 100 portfolio would be worth around £950.

No investment is without risk and there are inevitably highs and lows along the way. Nevertheless, declines of this magnitude would be difficult for even the most experienced, adventurous investor to bear. But for someone promising a soft investment ride, they could be terrifying. It could also take years to catch up with recent falls in value, a time frame that many cautious investors simply don’t have. After all, if a portfolio falls 20 percent, it requires a 25 percent rise to get back to where it started.

Why have these fund prices fallen?

Prudent model portfolios usually consist primarily of high-quality bonds, which are generally considered dull and low-risk.

Simply put, a bond investor lends a company or government a sum of money for a specified number of years. At the end of the term they get their money back. In the meantime, the investor receives regular interest, the so-called coupon, as compensation.

This strategy has proven successful for years. Investors are virtually guaranteed to get their money back, as the companies and governments they buy debt from are unlikely to default.

The returns paid aren’t very exciting – until recently, a large corporation or established government didn’t have to pay a lot of interest to convince lenders to buy their debt because the level of risk was so low – and interest and savings rates so low. Bonds are often seen as a good ballast for stocks. That’s because while stock prices tend to change dramatically, bonds (usually) take a tortoiseshell, steady, and slow approach.

In addition, bonds and stocks usually move in opposite directions, so when stocks fall, bonds rise, creating a useful portfolio balance. But in recent months, these trends, which have been around for years, have begun to fall apart.

The value of bonds has fallen as investors have become afraid of the creditworthiness of borrowers. Just a year ago, the British government paid just over 1 percent to investors in its 10-year bonds. Today it has to pay about 4 percent. When interest rates rise, the value of bonds falls.

Which prudent funds have taken a hit?

Most bond funds have fallen in value in recent months. The extent to which they are affected depends on the type of companies, sectors or countries in which they invest.

Low-risk model portfolios, which contain a high proportion of bonds, are struggling, especially those with a large weighting to UK bonds.

Santander’s Multi-Index Fund 1 contains 45 percent UK corporate bonds and 23 percent UK government bonds – the two largest asset positions. Vanguard LifeStrategy 20 consists of 80 percent bonds and 20 percent stocks.

Online investment service Wealthify says its portfolio dubbed ‘Tentative Plan’ is “suitable for investors who prioritize mitigating losses over high returns.”

But the fund has fallen more than 12 percent in the past year. In total, 43 percent of the portfolio consists of government bonds and 22 percent of corporate bonds. The ethical version of this portfolio has fallen even further, by more than 16 percent in a year.

NatWest’s lowest-risk model portfolio, the Personal Portfolio 1 Fund, has an appropriate ‘cautious and prudent’ badge. In the description, NatWest says, “Think of it like swimming in the shallow end with the peace of mind that you can stand up.”

The fund is down more than 13 percent in the past year. In total, 79 percent of the portfolio consists of bonds.

Investment platforms AJ Bell and Hargreaves Lansdown also offer prudent funds: AJ Bell Cautious and HL Multi Manager Equity & Bond. These have fallen less in the past year: 5.4 and 8.6 percent respectively.

Holly Mackay, of investment website BoringMoney, says the worst may not be over for these cautious funds.

“Low risk or prudent portfolios should ease investors’ minds,” she says, “but last month’s mini-budget scared the shit out of investors and normally quiet bonds have had a turbulent time. This means that many investors who opted for what felt safer were the most thrown out.’ She adds, “I don’t think it’s a good idea to get sold out going south, as counterintuitive as it may feel. But it does throw the investment industry’s gauntlet over naming conventions and how we describe collections of investments to consumers. There has been no hesitation about ‘prudent investment funds’ in recent months.’

Are model portfolios inherently flawed?

In recent years, most mainstream investment platforms have launched model portfolios designed to attract savers who want a simple, straightforward way of investing. Investors do not need much knowledge of investing to get started, so such funds often attract beginners.

Investors are usually asked a series of simple questions to determine their risk appetite. Depending on their answers, one of three to six model portfolios is recommended to them.

For example, Vanguard asks savers a series of six questions, such as how much they agree or disagree with the statement, “I prefer investments with little or no fluctuation in value, even if they offer a lower potential return.”

If someone says they strongly agree that they prefer little or no fluctuation, they are more likely to be sent to what Vanguard considers a lower risk fund.

These portfolios have been a useful service to investors for years. They’ve given savers access to investments without the need for costly financial advice, opening up investments to thousands who might otherwise be stuck with cash.

Over a longer period of time, the recent depreciation of prudent portfolios is not dramatic. For example, Vanguard Life Strategy 20 has fallen by 1.2 percent in five years.

However, Damien Fahy, founder of the personal finance website MoneytotheMasses, believes the recent losses recorded by prudent model portfolios indicate that more research is needed.

He says: “This year investors have learned that they need to understand the risks of what they are investing in, and that includes ready-made portfolios. That’s because every now and then it happens once every 100 years, which we’ve seen this year with the poor performance of both bonds and stocks.’

Many model portfolios consist of a simple mix of bonds and stocks which helps to keep them simple and costs low and in normal times this mix provides sufficient balance in a portfolio. However, the events of recent months suggest that this may need to be reconsidered.

Fahy adds: ‘It is possible to diversify a portfolio during a period when bonds and stocks are rising or falling at the same time. Cash, commodities and gold should all play a more prominent role in asset diversification than they may have done in the past decade.”

And finally, what should investors do?

Investors who sell their investments in prudent funds now will incur losses. However, those who persevere will see the value of their portfolios fall further. The hope is that the price of these funds will recover in the long term.

On Friday, Vanguard said investors should always focus on the long term — and remember that most portfolios have appreciated in the past two years.

It added: ‘It’s important to focus on positives – lower bond prices mean higher returns for investors. This means that bond yields are likely to be higher than they were in the future. With annual returns likely to be closer to five percent than the one to two percent we’re used to, investors have a chance to recoup some of those losses faster.”

In general, model portfolio investors may also want to explore whether they are getting the level of investment diversification they need.

While it’s thankfully an unusual time, recent months have reminded investors that bond and stock prices sometimes fall together – and that a cautious label can be quite misleading.