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Good havens

There was a time when it seemed that investors had it all – double-digit returns, stratospheric dotcom prices and remarkably bullish markets. Investing seemed easy and people were prepared to take enormous risks to net great returns. High-fliers ignored salaries and bonuses in favour of share options.

Now the market has grounded with a bump. Equity markets have plunged. Poor-quality bond issues have led to plummeting bond fund values. Scandals such as Equitable Life, combined with the recent zeros debacle, have compounded this to generate rock-bottom investor confidence.

Where can investors go from here? The answer, if investors do not expect the returns of the 1980s and 1990s, is low-risk investing. Before explor-ing this sector, it is important to note that low risk does not mean no risk. Some months ago, zeros would have featured in the low-risk section of many portfolios. Nowadays, they are most likely found in the high-risk section.

It is vital to create a clear definition of what constitutes low-risk investments. Generally, investors looking for the lowest-risk collective investments are likely to find themselves investing in the money-market and UK gilt sectors.

Money market funds are designed to protect capital and invest at least 95 per cent in money market instruments such as cash, bank deposits, very short-term fixed-interest securities, floating-rate notes and certificates of deposit. They have delivered steady, albeit unspectacular, returns over the last few years, with top performers delivering around 14 per cent over the last three years.

This may seem paltry but such performance looks spectacular compared with recent equity performance. The FTSE 100 is down by some 2,000 points over three years – a fall of 30 per cent. The bestperforming money market funds have outperformed the FTSE by some 45 per cent.

Yet, over one year, money market funds have performed at 4 per cent while inflation has been running at around 2 per cent, creating real gains of only 2 per cent. Indeed, if money market funds are not kept in a tax-efficient wrapper, returns can be further eroded by tax.

The UK gilt sector has, on the whole, offered positive returns and its top performers have outperformed money-market funds over one year. Gilt funds invest 90 per cent or more in Government securities. Gilts are considered one of the least risky sectors since the Government has yet to default on any of its bond issues.

Although the gilt sector has been overshadowed by the strong performing corporate bond sector over the last couple of years, scandals such as Enron and the risk of further defaults means that corporate bonds are not looking strong. There are likely to be more low-quality bond issues as companies avoid fund-raising on volatile equity markets. History has shown a counter-cyclical correlation between corporate bonds and gilts – when gilts are performing well, corporate bonds are not and vice versa.

The Government has announced the issue of £23bn of gilts in 2002/03 in response to its move from fiscal surplus into deficit. Most analysts believe the issues are fully discounted by the market and that excess demand will be taken up by institutions. Nonetheless, some believe that the Government&#39s GDP projections are overly bullish and further gilt issues may be needed to make up the fiscal deficit. This paper would have to be issued at competitive rates, making the sector an attractive prospect.

The ongoing attractiveness of gilts depends largely on Government issues and how other fixed-interest sectors perform.

Although hedge funds are normally associated with high-risk investing, they can be instrumental in a low-risk investment strategy. There are a number of hedge funds designed to create strong returns off exceptionally low volatility.

Momentum&#39s Allweather fund, for example, delivered a return of 6.71 per cent in 2001 and has been offering annualised returns of 9.73 per cent since its inception in 1995 at a volatility of 3.64 per cent. The corresponding Allweather liquidity fund returned 5.36 per cent in 2001 at a volatility of 1.63 per cent. Such strong returns in falling markets is a consistent feature of low-risk hedge funds. Indeed, up to January 2002, the Allweather fund had only five months in which its values fell.

Low-risk investors can further diversify their risk by using a fund of hedge funds to access a range of investment management styles and expertise.

However, charges tend to be much higher than those levied on UK gilt and money-market Funds although hedge fund managers are normally paid on a performance rather than front-loaded basis. But investors should consider that hedge funds are unregulated collective investments and do not offer the degree of consumer protection that FSA-regulated funds would offer.

Tax status is also important, as most hedge funds operate on a non-distributor status. This means that any gains realised attract income tax. For this reason, hedge funds are normally put into tax-efficient wrappers such as Sipps or SSASs. Hedge funds with distributor status attract capital gains tax, making them more attractive.

As minimum investment criteria for hedge funds fall, more funds of hedge funds will be made available to the retail market and look set to become a popular means of low-risk investing. Currently, these products are only really suitable for high-net-worth investors.

Investment theory says that courageous investors should invest in equities now, as the market cycle looks to be reaching its nadir. But it may well be that investors have been burnt one time too many and, rather than seek the spectacular, will look to more sure returns.

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