AFI Cautious Index: Getting more cautious

The highlights of the rebalancing were a retreat from exposure to UK Equities and increased allocation to cash and fixed income. Season nine also witnessed a jump in popularity of a number of absolute return funds. The trend was for a clear shift away from growth and an increased focus on capital preservation.

The panellist’s scepticism of UK equities looks to have been well founded, in the three months since the rebalancing took place the UK equity market, as measured by the FTSE All Share index, has fallen by 4 per cent. By contrast the AFI Cautious index gained 2.14 per cent over the same period. The shift to fixed income also appears to have been a shrewd move, the IBOX Sterling corporate AAA all maturities index returned 9.51 per cent over the three months. The increased allocation to cash hasn’t contributed much in the way of positive returns; the IMA money market sector index fell by 0.29 per cent, a victim of the plunge in interest rates. It has however limited the downside of the portfolio and provided a degree of capital protection, undoubtedly what the panellist were hoping for.

You don’t get to be an AFI panellist for nothing and the decision to move out of equities and into bonds in the current climate isn’t enough to mark you out as a leading financial adviser. Fund selection is how they earn their keep, and here we can see some pleasing results. Of the thirteen funds added to the index only one, the Dimensional UK Core Equity fund lost any money over the period.

The top contributor to the index’s performance for the three months in question was the Newton International Bond fund. The fund, managed by Paul Brain, invests globally in sovereign debt and has outperformed the IMA Global bonds sector by 5.64 per cent for the three months to the end of January placing it comfortably in the second quartile. While the fund has performed well it is not a stand out performer; yet its heavy weighting in the AFI Cautious index, it accounts for 3.1 per cent, means that it alone contributed 0.5 per cent of positive returns. In an index of 96 funds that only returned 2.14% in total this is quite an achievement; highlighting the importance of good asset selection over good fund selection.

Other top contributors to the index were the M&G Optimal Income fund, the highest weighted fund in the index which although performing unspectacularly contributed a solid 4 per cent to the index’s performance. Newton Global Higher Income and Invesco Perpetual Corporate Bond, both in the top five by index weighting, have ranked in the top five by contribution, adding 0.25 per cent and 0.12 per cent respectively. This seems to reinforce the decision to increase allocation to fixed income, and with all these funds being in either the first or second quartile it also vindicates the panel’s fund selections.

The big surprise came from the Black Rock Gold and General fund which although only accounting for 0.5 per cent of the index managed to contribute a fraction under 0.3 per cent to the overall return. A huge surge in demand for gold investments saw the fund return 58.05 per cent in only three months.

As well as the winners there were of course some disappointments. Chief among them is the Old Mutual Corporate Bond fund which made rather pitiful returns of -13.39 per cent and being a popular choice with the panel, it accounts for 2.8 per cent of the entire index, this has had a serious drag on returns of -0.38 per cent.

One of the stand-out features from the rebalancing was the amount of faith being placed by the panel in absolute return funds. Two new entrants, the Cazenove UK Target Return fund and the CF Ruffer Total Return fund, accounted for quite a sizeable amount of the index given their relatively short track records. That faith looks to have been repaid with these funds contributing 0.5 per cent and 1 per cent to the index’s performance respectively. While these figures sound low, it is important not to underestimate how useful absolute returns fund could be in meeting the index’s objectives. The CF Ruffer Total Return fund returned 16.1 per cent over the period. Absolute returns in falling markets are the holy grail of cautious investing.

Other funds that promised much but delivered little were the New Star Sterling Bond fund, the New Star International Property Fund and the Scottish Widows Investment Partnership Absolute Return Bond fund. These three funds were all inside the top twenty in terms of weight in the index but languished at the bottom of the scale in terms of contribution to the index. They are responsible for returns of -0.33 per cent, -0.36 per cent and -0.32 per cent respectively.

The AFI Cautious index is about more than just returns, however. Constructed with a person in the latter part of their working lives or possibly early in the retirement phase in mind, the key aim of the cautious index is to preserve spending power in real terms while minimising risk. To this extent the rebalancing looks to have achieved its aim, although it far too early to tell what the actual outcome will be given the seven to ten year time horizon associated with the cautious index.

The season nine AFI Cautious index has reduced volatility compared to its season eight predecessor, with annualised volatility being a full fifty basis points lower. The season nine iteration outperformed the earlier version by 1.52 per cent. This alteration to the index’s risk and return profile might not look that significant or even interesting on the surface but is a key indicator or the benefits of having a panel of the leading fund advisors. The panel have managed to identify which funds are not suitable for the current market conditions, and which ones offer the best potential. While it may seem the obvious thing for a professional advisor to be doing, getting it right on a continuous basis is a very rare characteristic. These changes go a long way to ensuring the index meets its theoretical objectives of beating inflation with minimal risk.

Looking ahead to the next rebalancing in May I think we will see a fair amount of portfolio turnover. Perennial favourites New Star are likely to suffer from their instability. In particular, the New Star International Property fund, currently accounting for 2.7 per cent of the index, has had a rather ignoble and public fall from grace and coupled with its recent poor performance is a favourite for the boot.