22 fund and trusts to see you through stock market volatility

Amid the volatility that has gripped global stock markets since early August, it is not surprising that funds focusing on fixed-interest investments have been among the best performers.

Data from the 'top-performing sectors' section on our homepage confirms that just three Investment Association fund sectors made positive returns in August: UK gilts (which led), UK index-linked bonds and global bonds.

I certainly won't be following the herd into the perceived safety of government bonds. Recent market volatility and weaker inflation numbers may delay the mooted increases in UK and US interest rates, but any sniff of rising rates on the horizon will see bond investors running into cash.

Capital values on bonds will fall, and there will be scant compensation from the resulting rise in current skinny yields, which are less than 2 per cent on benchmark UK government 10-year bonds.

EM COMEBACK?

There will be a time to invest in the government bonds of developed markets again, but that time is not now. For a more speculative and potentially more rewarding punt, emerging market debt funds could stage a comeback.

These have already been hit by steady outflows as global investors flee from emerging market debt and equity.

Funds that invest in local currency debt, such as Investec Emerging Market Local Currency Debt, have been hardest hit, falling by close to 20 per cent over the past year and losing a quarter of their value over three.

Such funds have lagged those that prefer emerging market bonds issued in dollars, where losses have, in the main, been negligible over the past year.

Investors seeking a portfolio diversifier could be well served by such a local currency fund. However, one that blends exposure to emerging market bonds issued in both local currency and hard currency (the dollar) should prove less volatile, particularly one such as Aberdeen Emerging Market Debt, run by a management group that knows the asset class well.

And although total return rather than a focus primarily on yield is arguably a better strategy to adopt for this asset class, the current yield on the Aberdeen fund is a fairly meaty 5.9 per cent.

INVESTMENT TRUST PICKS

Among investment trusts, the sectors that bucked the 10 per cent-plus falls in global equity markets during August include two tiny property sub-sectors (Direct Asia Pacific and Direct Europe), along with specialist leasing and liquidity funds.

In volatile times, one would also normally expect smaller companies to suffer more than their larger brethren because investors view them as being far more risky. However, investors in UK smaller company funds and trusts have not, in the main, been buffeted by the summer storms.

Before examining what lies behind their relatively strong performance, it's worth highlighting the fact that market volatility has had some analysts sniffing a bargain or two, particularly among investment trusts, which are generally my preferred collective investment route.

The fear stalking markets today is throwing up opportunities to buy investment trusts with decent performance records at bargain prices. But it should also be pointed out that, if the bears continue to dig their claws in, they could get cheaper still.

Iain Scouller, investment company analyst at stockbroker Stifel, highlights Genesis Emerging Markets, International Biotechnology trust and Witan (a Money Observer Rated Fund) as falling into bargain territory.

CONTRARIAN STANCE

Taking a contrarian stance in these volatile times should not be ignored, but it can be an uncomfortable ride. The legendary value investor Sir John Templeton described it thus: 'To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.'

Highlighting that quote in a recent report on contrarian opportunities among investment trusts, Alan Brierley and Ben Newell at stockbroker Canaccord Genuity point out that a 'value' stance (buying good companies at cheap prices) has underperformed growth (buying stocks on high price/earnings ratios) by a significant margin since December 2006.

The MSCI AC World Growth index has made a total return of 60 per cent in that period, compared with just over 20 per cent for the World Value index.

From a contrarian value perspective, the Canaccord analysts have slapped a 'buy' rating on two trusts that have suffered large falls: Murray International and Templeton Emerging Markets (both Money Observer Rated Funds) - although they warn these could also be classic 'value traps', in that they are cheap for a reason.

They also rate British Empire Securities & General a 'buy', but acknowledge that patience in the trust's overtly value-based strategy is wearing thin.

The stockbroker places BlackRock World Mining in the same contrarian value camp, but places a more reticent 'hold' rating on the trust, fearing that the gut-wrenching falls in commodity prices may be the 'canary in the coal mine' for global economic growth prospects.

It reckons BH Macro, a hedge fund of funds, should also provide decent defensive diversification, along with the capital preservation-focused Ruffer Investment Company.

Indeed, investment trust fans who want capital growth with a defensive mindset should assess the current constituents of Canaccord's model portfolio. This model has returned around 130 per cent since December 2007, compared with just over 30 per cent for the FTSE All-Share index.

I already hold several of these trusts in my portfolio, and in these volatile times I'll be exploring opportunities to add those I don't hold that Canaccord currently rates as a 'buy'.

SMALLER COMPANY SURVIVAL STORY

UK smaller company funds and investment trusts have continued to build on their superior performance so far this year. The main reason is a general lack of exposure to the sectors that have dragged the FTSE 100 down - basic materials as well as oil and gas.

The table below shows that the typical UK smaller companies trust is heavily weighted to industrials and consumer/support services - sectors that aren't well represented in the FTSE 100 index, which is far more exposed to what is going on in China and other foreign markets. UK smaller company funds and trusts, in contrast, have a more direct correlation with what is happening in the UK economy.

Clearly, there is a risk that continued high volatility will make its way further down the market capitalisation scale. Other influences such as the UK's place in Europe could also weigh on sentiment if the outcome to the 2017 referendum looks like pointing to an exit from the EU.

For now, however, the relative buoyancy of the UK economy points to further good times for small company funds and trusts.

The sector could also get a short-term boost in another way: next year's introduction of the new dividend tax regime will prompt some dividend-paying smaller companies, particularly those with controlling family interests, to accelerate dividend payments into the 2015/16 tax year.

AIM PRESENCE

Funds and trusts that could benefit most are those that have a large presence on the Alternative Investment Market, where many family controlled companies are listed.

Investment trusts that could see a one-off boost through special dividend payments include Diverse Income, which has a 60 per cent-plus weighting in Aim, and other mainstream funds such as Henderson Opportunities and its stablemate Lowland.

More focused and growth-oriented smaller company open-ended funds that have a high weighting to Aim shares include Marlborough UK MicroCap Growth, Cavendish Aim, Axa Framlington UK Smaller Companies and Franklin UK Smaller Companies.

Investment trusts in that category include Standard Life UK Smaller Companies, BlackRock Smaller Companies and its stablemate Throgmorton, Strategic Equity Capital and Miton UK Micro Cap.

Finally, a word of warning to all those income-seekers out there. The historic dividend cover ratio (a company's earnings divided by dividends paid) on the FTSE All-Share index has fallen to around 1.8 times, compared with around three times just four years ago. This last happened in 2009, and before that 1999.

Given that the FTSE 100 represents approximately 80 per cent of the All-Share index, income-seekers should consider focusing their attentions further down the market capitalisation scale, where there are plenty of under-researched and under-owned companies with progressive, sustainable dividend policies, not to mention the companies that could provide a one-off income special before the end of the tax year.

A TIP FOR CONTRARIAN INVESTORS

Bargain hunters and contrarian investors can get a snapshot of the worst (and best) fund and trust sectors over the short term via our homepage.

You can do this by ranking each of the sectors from the worst to the best performers over one month and then repeating the exercise for each sector's constituents by clicking on the sector links.

You can also narrow down the choice by focusing on our Rated Fund asset groupings, which include both open-ended funds and investment trusts.

A further twist to this type of analysis is to find the best performers in an out-of-favour asset class. For example, in the Rated Funds Asia Equities asset group, the most resilient performance over one month (to 3 September) comes from First State Asia Pacific Leaders, which fell by 7.1 per cent.

This short-term performance, plus a read-through to longer-term performance figures, shows that this fund is proving to be extremely resilient in good times and bad, with a top-decile ranking in the Investment Association's Asia Pacific excluding Japan sector.

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