The highly rated pair say that the current strength of equities is still dependent on central bank largesse, and therefore very fragile. The sharp crashes in stockmarkets this year show investors are not trading on fundamentals, the managers claim.
"Why do we not trust this buoyant equity market? As we come out of earnings season, it is reasonable to conclude that corporate earnings growth has been lukewarm at best and yet indices continue to hit new highs," they said.
"There is money to be made in this market but it comes with considerable risk – namely the hope that you can ride the wave of central bank largesse and get out before the next man."
"The examples of market turning points in 2000 and 2007 would suggest that few achieve such an elegant exit."
"It is impossible to calculate how much hot money is playing this game, but the falls in May and June give some indication."
Data from FE Analytics shows that the MSCI World index lost 9.37 per cent peak to trough between 22 May and 24 June.
Performance of MSCI World in 2013
Source: FE Analytics
The reason was the growing belief that the US Federal Reserve would withdraw from its money-printing programme, which Russell and Baillie think has been supporting equity prices.
As soon as it seemed there was a real prospect of QE being withdrawn, many investors rushed to the exit, and the managers say betting on the policy decisions of the Fed is far too risky for investors who prioritise capital preservation.
"The intricate dissection of Fed rhetoric is another example of how jittery the risk takers have become – this month the omission of a single sentence from the Fed’s statement provoked the conspiracy theorists into action," they said.
The managers are sceptical that the Fed can avoid similar crashes when it does eventually seek to withdraw from its policy.
"Is it possible that the Fed has become too transparent? Of course, central banks will hope that they can temper market enthusiasm before tapering, but the dry run earlier this year did not go very smoothly."
"The best argument for equities today is the lack of alternatives and that is not a good reason for holding any asset class for longer than the short-term."
The £335m Ruffer Investment Company has made just 12.16 per cent this year compared with 20.14 per cent from the average Global Growth trust.
Performance of trust vs sector in 2013
Source: FE Analytics
However, this is unlikely to concern the managers, who aim to produce a superior return to cash.
They have underperformed the sector in every year the market has risen since 2007 but performed much better in the two bad years of 2008 and 2011.
For this reason they were among the top-performing trusts in the sector for a number of years following the 2008 crash, having made 23.01 per cent in that year as their peers lost an average of 30.13 per cent.
Performance of fund vs sector in 2008
Source: FE Analytics
The trust has the second-lowest volatility in the sector over the past five years and the fourth-highest Sharpe ratio – a measure of risk-adjusted returns.
They take a multi-asset approach to achieve these results, and have long held a high weighting to inflation-linked bonds.
The managers believe that there is a very real chance of damaging inflation that the market does not fully appreciate, as FE Trustnet discussed this morning.
They have also retained a significant position in gold bullion worth 4.9 per cent of the portfolio despite the bad year for the metal, explaining that it continues to provide protection from the tail risks of sovereign defaults.
Building a portfolio with assets that will do well when others in the collection will do poorly is the key to their steady returns.
The managers say that while they remain cautious about the prospects for markets, they have been preparing for a scenario in which they are proved wrong in the medium-term.
"One of the threats to our current defensive positioning is that exuberant equity markets continue to spiral higher on the expectation of a never-ending supply of easy money propping up asset prices and an acceptance of ZIRP [zero interest rate policy] and QE as the norm, which of course they are not," they said.
"In such an environment, our protective positions in the company will suffer (much as they did in late 2006 and early 2007) and so we need the equity book to fight hard for us."
"With this in mind, we added two copper miners to the portfolio during the month – they will be beneficiaries of the perception of a better growth outlook and a weaker dollar – two factors that would hurt our defensive positions."
"Such offsetting assets are preferable to the alternative of reducing the portfolio’s protection and hoping that we are not left exposed if the tide of central bank liquidity recedes."
The managers acknowledge that the trust could underperform in the medium-term if the current QE-fuelled rally continues; nonetheless, they are sticking to their defensive approach.
"If markets continue their upward trajectory, then Ruffer Investment Company is going to look like a dull place to be invested."
"Hopefully we will continue to make modest progress but, as ever, our focus is at the other end of the spectrum and if reality bites, we hope to protect our investors from the pernicious effects of the ensuing hangover."
"In the meantime those equity positions will have to work hard to keep the bottom line plodding along."
The trust has an annual management charge of 1 per cent and no performance fee.
