Two funds with downside protection

At times of extreme market stress it is the funds that hold reliable protection such as options that have the best chance of safeguarding your capital. 

A prime example is the £410m Ruffer Investment Company (LON:RICA) that has capital protection at the heart of its mandate. It went into this crisis with 40% in equities and 30% in cash and highly liquid cash equivalents, with the balance in other defensive areas including illiquid strategies and options.

Balanced approach

In their latest update the managers said that the options and credit protections have contributed positively through the recent market turmoil. They admitted that the equity investments are suffering, but explained that the performance is balanced by the protective assets, which are working broadly as expected.

“The unconventional protective assets are benefiting from increased volatility, fears in the credit markets and movements in currencies. Volatility options have contributed significantly in the last few weeks and the credit protections are coming to life.”

It has not all worked as envisaged with their gold mining shares significantly underperforming gold this year and the increase in the value of the index-linked bonds being limited by the fall in inflation expectations, but it’s their derivative protection that has saved the day.

At time of writing on Monday morning with the markets in freefall the shares were unchanged and year-to-date they have held their value. Investec has recently issued a buy recommendation.

The insurance pays off

Another fund that has consistently used options to provide downside protection is the £280m Diverse Income Trust (LON:DIVI). It operates in the UK Equity Income sector yet maintains this defensive insurance, which as far as I know makes it unique.

According to the latest accounts, the fund held a listed put option on the FTSE 100 with a strike price of 6,300 and an expiry of December 2020. At the time with the index trading above 7,500 it was well out-of-the money, but the recent market falls have taken the FTSE well below the strike price and turned it into a valuable holding.

On 12 March the managers provided an update in which they announced that the elevated market volatility and lower levels of the FTSE100 had led them to take profits on the put option in two parts during the course of that week. Both of these factors would have added considerably to its value.

They said that the realised profits would be added to cash balances and used to add to the portfolio at low valuations. On 12 March almost 15% of the net asset value was held in cash.

Given the scale of the sell-off on Monday morning the sale looks premature, but it is unfair to judge them with the benefit of hindsight. The put option wasn’t enough to stop the fund from taking a battering, yet it has outperformed the FTSE 100 by around ten percent year-to-date and the large cash weighting should provide an element of protection with the possibility of strong gains in the future.