With investment markets around the world showing increased signs of volatility, it is hardly surprising if investors seek to bring some stability to their portfolios. And, in theory at least, the two most stable groups of open-ended investment funds should be those investing primarily in cash and those which seek to provide a degree of capital protection, which in some cases, can amount to an absolute guarantee that a set unit value will be maintained.

The relevant sectors are those for Money Market funds and Capital Protected and Guaranteed funds. In its performance categories, the Investment Management Association brings these two sectors together under the general heading of ‘funds principally targeting capital protection’ and, in view of the volatility inherent in most investment markets, it may come as a surprise to realise just how few of these funds there are.

A minority interest
Even combined both sectors cover less than 50 funds, accounting for under two per cent of the total of funds under management in UK-authorised unit trusts and OEICs. This reflects the fact that the investment fund sector as a whole has been far more concerned over the years with the provision of actively managed funds, targeting either income or capital growth and predominantly based on equities.

Capital protection is viewed as a specialist area and one that is neither particularly exciting nor likely to provide spectacular returns. While a growing number of fund management groups have added a cash fund to their ranges, in recognition of the fact that a move into cash is, from time to time, a sensible asset allocation decision, the provision of equity-based funds that lock in an element of capital protection remains the preserve of a handful of specialist providers/

Capital-protected funds
To deal with the capital protected funds first, this sector contains a range of approaches, with the capital protection available varying between 100 per cent and 90 per cent, depending on the fund concerned. All open-ended capital-protected funds have to maintain a balance between delivering the level of capital protection they promise and enabling investors to get in and out of the funds as they wish.

Typically, such funds operate on the basis of locking in gains over particular periods, say every three months. So in practice, with such a fund offering a 100 per cent guarantee, the value of it at the end of its first quarter would form the floor price for its units. At the end of the next quarterly period, if the market has fallen, the price of the unit remains the same, providing the guarantee, but if it has risen, then the unit price will also rise and this sets a level for the new floor price in the future.

With funds only protecting 95 or 90 per cent of the unit price, the process is similar, although in the case of the former, prices can fall by up to five per cent a quarter before the capital protection kicks in. In the latter case, the fall can be up to ten per cent a quarter. So a 95 per cent-protected fund could, in theory, lose up to 20 per cent of its value in a year, if markets kept falling, and a 90 per cent-protected fund up to 40 per cent.

Lower volatility
The attraction of the more limited protection is that if markets rise you capture more of the upside. As you would expect, the capital-protected funds as a group have a relatively low level of volatility, particularly those that aim for 100 per cent capital protection.

In its most recent survey of the sector, fund monitoring service Trustnet reported that over the three years to March 2007 these funds had posted an average return of 30 per cent with an average volatility of 4.27 per cent, commenting that this was ‘a respectable reward over and above risk-free deposits’.

However, the report added, ‘With the rise of structured products, which provide a similar combination of capital protection and market participation, a question arises about how this group of vehicles continues to exist – and even expand.’ The answer is that they provide a more flexible option for investors looking to limit the downside risks to their portfolios, by doing so on an ongoing, open-ended basis, while most structured products are set up to run for a fixed period only.

As the table on page 76 shows, taking each fund’s ‘Sharpe Ratio’ as a measure
of volatility, the volatility is even lower over shorter periods in most cases. This indicates that by and large these funds are doing the job they were set up to do, although investors need to understand the nature of the capital protection being offered in each case to ensure that it fits with their goals and objectives.

Going into cash
It should be pointed out that capital protection is not the primary goal of most Money Market funds. These are generally focused on generating a higher yield than is available from mainstream cash deposits, although because they are doing this from risk-free, short-term cash and cash-like holdings, their strategies have the by-product of helping to reduce investment risk.

These funds also display the advantages common to most investment funds – a broad spread of holdings, low cost of entry (investors can expect minimum investments typically to be £500) and low costs. Cash funds are cheaper to run than equity funds, so they generally do not levy initial charges and their annual management fees are between 0.25 and 0.50 per cent.

What will really surprise many investors is the range of returns posted by a group of funds that, ostensibly at least, invest in the same things. Trustnet’s most recent review of the Money Market fund sector, looking at performance over three years to the end of September 2007, found that while the average return over that period was 10.4 per cent, individual fund performance over the period ranged from 15.4 per cent down to 6.4 per cent. As the report noted, ‘Whether these levels of return are satisfactory enough for an investor to pay 0.5 per cent in AMC is moot.’

Active management
Another surprising factor is the range of volatility figures posted by what are supposed to be low-risk funds. Again, there is significant diversity in terms of sharp ratio figures between funds and also with regard to the same funds measured over different periods of time.

It is as well to remember here that just because they invest in Money Market instruments, it doesn’t mean that these are passively managed funds.

Indeed, depending on the strategy of a particular fund, some of these portfolios can be very active indeed. It is also important for investors to appreciate that the managers of Money Market Funds don’t simply invest in a range of savings accounts and forget about them. There is a broad range of increasingly sophisticated Money Market instruments at their disposal and in some cases their portfolios are closer to a high-quality bond fund than a cash deposit.

Looking at volatility, the TrustNet report added that ‘Some, albeit low-level, volatility exists, coming in at an average 0.3 per cent over the period. Within this, however, there are funds for the unwary that manage to inflict fluctuations either side of their mean return in excess of 1.65 per cent. Ultimately, investors may do well to consider the cumulative drag on their money here – the pedestrian returns; the potential cost, however small, of the volatility element; the charges they’ll pay for the privilege – and then see how the cost/reward equation compares to a mundane high street deposit arrangement.’

Choosing a fund
So Money Market funds are not necessarily a straightforward alternative to a deposit account, but they do provide a convenient way for investors using a portfolio of funds to put some of their asset allocation into cash. Choosing which fund to use in such circumstances might be a bit more problematic, given the range of performance across the sector.

However, this is one fund grouping where past performance figures are a sensible place to start, since it is highly likely that funds that have delivered more than their peers in the past, whether it’s because of a particular investment strategy or lower costs, will continue to do so in the future.

We have dispensed with our usual Roll of Honour based on the Lipper Leaders analysis this month, since its criteria fail to throw any meaningful light on the relative merits of these two distinctive groups of funds. Instead, we list the constituents of each sector, showing how long each fund has been running and its total return over six months, one year, three years and five years. For the capital-protected fundsthere is a second table showing the fund size, its current yield and the Sharpe Ratio volatility indicators for the same period.

In each case it is  matter of finding a fund that fits the risk profile of your portfolio if you want to take advantage of the opportunities for risk management afforded by one of the most risk-averse sectors in the investment fund universe.