Is it time to build a defensive portfolio?
How advisers can build a defensive portfolio in a fluctuating economy
Defensive portfolio investing, historically, has been as simple as increasing exposure to bonds, in particular government bonds.
However with yields having plummeted, bonds are not as defensive as they once were.
The main developments are along the lines of looking at the correlation of assets over longer timescales and ensuring a broader exposure to different asset classes.
In the last 20 years it has become easier for investors to access gold, commercial property as well as hedging strategies.
While having a defensive strategy might make sense in the current geopolitical environment, what has traditionally worked in terms of defensive equity exposure may not work this time, when volatility is factored in.
It is almost impossible to predict Brexit or the US-Chinese trade wars, while on the periphery is the rising tension in the middle east.
In this report we look at how the rules are changing when it comes to how investors can build defensive portfolios.
Most advisers have not allocated clients’ assets to a defensive portfolio
Most advisers have not allocated clients’ assets to a defensive portfolio, according to the latest FTAdviser Talking Point Poll.
The poll asked advisers the following question: “How far have you allocated clients’ assets to a defensive portfolio?”
Most advisers who responded (43 per cent) said not at all.
Many advisers use a range of managed or multi-asset type funds where the fund managers may well be adding defensive assets.
One third of advisers said they allocated only a little to defensive assets.
Some 10 per cent said quite extensively, meanwhile only 14 per cent of advisers have solely invested clients’ money into defensive assets.
Alasdair McKinnon, lead fund manager of the Scottish Investment Trust was not surprised by the results.
“As markets have generally had a healthy 2019 it is unsurprising that the current survey positioning is essentially bullish.”
He added: “Defensive assets have been out of fashion this year and, in aggregate, people want to give the ‘right’ answer.”
Defensive assets typically include investments such as cash and fixed interest securities such as bonds. They usually pose lower risk and return levels.
Defensive assets are often added to multi-asset funds to diversify returns.
Scott Gallacher, chartered financial planner at Rowley Turton Private Wealth Management, said most advisers will aim to construct well-diversified portfolios tailored to their clients particular risk profiles.
He added that he does not expect short-term market concerns to increase asset allocation to defensive assets as advisers often tell their clients to adopt a long-term view.
If markets have a tumble, as they did at the end of last year, defensive assets provide some cushion to break the fall.
Mr Gallacher said: “Many advisers use a range of managed or multi-asset type funds where the fund managers may well be adding defensive assets; consequently [these situations] would be even less reason to specifically add defensive assets for their clients.”
Mr McKinnon said: “If markets have a tumble, as they did at the end of last year, defensive assets provide some cushion to break the fall."
“There is no ideal allocation for defensives but perhaps the key point is to ensure that there is a sufficient amount, in order to avoid panic selling at a market low,” added Mr McKinnon.
How to build defensive portfolio in volatile market
Words: David Thorpe
Adding defensive exposure to a portfolio has traditionally been more about the “when” than the “how”.
The challenge that has faced advisers is understanding the direction of the market and the outlook for the economy.
If they got those questions right, the question of how to make client portfolios more defensive was relatively easy.
In the event of an economic downturn, traditionally, government bonds would rise in price as investors take the view that, even in the worst of all worlds, governments can make payments, making the bonds they issue a safe haven.
That means, historically, that advisers wanting to construct a defensive portfolio simply had to sell off some of the equities they own, and buy more government bonds.
Despite the ten years of growth we have had, it is the traditionally defensive equities that are expensive, and the more economically sensitive ones that look cheap.
Within the equity part of the portfolio, advisers could simply choose funds with less exposure to the wider economy, and more capital invested in companies less reliant on the health of the wider economy to help them to grow.
According to Scott McKenzie, equity fund manager at Saracen, those sorts of companies include food and drink businesses, and utilities.
Food and drink companies are often called bond proxies, because they generate a reliable and steady income in the way many bonds do.
Those stocks, examples of which include Unilever and Diageo, tend to perform better than the market as a whole.
This is because investors buying bonds for defensive protection, will push the price of those bonds upwards, and thus the income yield that can be got from them downwards, making the equities that perform most like bonds relatively more attractive.
Impact of low interest rates
The prevailing low interest rate environment since the global financial crisis has kept bond yields low, and contributed to the strong performance of funds that are invested in those stocks.
But what has traditionally worked in terms of defensive equity exposure may not work this time, according to Mr McKenzie.
He said this is because, if the market is typically about to enter a downturn, it will have happened after a period of strong performance and robust economic growth.
Buying quality assets cheap with a margin of safety is the essence of defensive investing.
In that climate, the shares that move mostly in line with bonds will have been less popular with investors, and trading cheaply, while those that are most sensitive to the performance of the wider economy will have done well as the economy does well, and be trading at a high valuation.
This means that as an adviser sees the economy slowdown, historically he has been able to sell the economically sensitive stocks when they are trading at high valuations, and buy the more defensive equities just at the point they are cheap.
But Mr McKenzie said: “The problem with that is, despite the ten years of growth we have had, it is the traditionally defensive equities that are expensive, and the more economically sensitive ones that look cheap.
"That's why I don’t think buying shares like Unilever at this time is defensive. I think the valuations at which they trade makes then risky.”
Will Mcintosh-Whyte, multi-asset fund manager at Rathbones said: “I would look at shares such as Unilever and Diageo as a hedge against a recession, and I do think they would perform better than the more economically sensitive shares in the event of a downturn.
"I do think they would do that job, but at the valuation levels they are now, I don’t think they would rise in value in a downturn, just that they would fall less.
"And I would be wary of paying too high a price for something that is a hedge against a particular event, because the event might not happen in the way you expect.”
Bonds and equity challenges
The challenge faced by equity investors seeking to take the traditional approach mirrors the dilemma faced by those who want to use government bonds for the same purpose.
With greater certainty on Brexit it is likely we will see further gains in UK cyclicals, not only in the financial sector but house builders, retail and telecommunications, which would all benefit from a managed withdrawal.
Typically, if an economy has been growing consistently for a decade, inflation should have been rising, and the higher prices would make the fixed income available from bonds less attractive, as the purchasing power of the income is reduced by the inflation.
An economic downturn would typically mean that inflation falls, increasing the value of a fixed income, and so, making the bonds more attractive.
But the past decade of economic growth has been accompanied by inflation being mostly below target, and, as a result, bond yields have been at record lows.
So bond prices have risen alongside equities, making those bonds more expensive than is usually the case when an economy has performed well.
This means investors buying government bonds are paying record prices, when typically at this stage of the cycle they would be paying low valuations.
Thushka Maharaj, global strategist at JP Morgan said that while government bonds are expensive, each time over the past decade that there has been a downturn in markets, or a rise in political uncertainty, bond yields have fallen even further, generating a profit for clients, and performing the traditional defensive role advisers associate with them.
John Husselbee, multi-asset fund manager at Liontrust, noted that amid the sell off in global equities over the past year, government bonds have performed well, demonstrating that the traditional correlation remains intact.
But Peter Elston, chief investment officer at Seneca, said he views the prices of government bonds as very unattractive right now, relative to the risk that the next economic shock comes from a stark rise in inflation.
Both Mr Elston, and David Jane, multi-asset fund manager at Miton, dislike the investment case for bonds, but are not confident enough about the prospects for the global economy to replace the bond exposure with equities.
Mr Elston has bought gold as a hedge against inflation rising, and replaced the bonds with investment trusts in niche areas that pay an income.
Ms Maharaj said if there is another economic downturn, the likelihood is that central banks will not be able to intervene, as interest rates are already at or near record lows.
As a result, she expects policy makers' response to the next recession to be increased public spending, and that would create inflation.
I think if you have a long-term time horizon, the best option may be just to stick with equities.
With that in mind, she anticipates that adding products that perform well in an inflationary environment, such as gold or equities that have been out of favour in the low inflation world of the past decade such as those in the banking sector, would offer protection against the risk of inflation, and so are defensive.
James Burns, who runs the Smith and Williamson Defensive Growth fund, uses structured products, instead of bonds, as a way to gain protection from falling equity markets.
These products can be structured so that an investor gets paid even if there is some fall in the level of an equity market, and often gets paid an annual income as long as the fall is within a specific range.
Absolute return funds
He is also keen on absolute return funds, as he believes those can invest in a sufficiently wide range of products that the returns are not linked to prevailing market or economic conditions.
Mr Husselbee said lack of correlation is his concern about absolute return funds.
“The performance of the investments is entirely reliant on the skill of the manager and that makes us nervous.
"I think if you have a long-term time horizon, the best option may be just to stick with equities.
"The volatility will be there of course, but over time so will the returns. I can also see a place for gold in portfolios.”
If the traditional asset allocation assumptions that underpin defensive portfolio construction have to be questioned in a world of low interest rates, perhaps the simplest way to construct a defensive portfolio is to buy those assets which are cheap, as whatever bad news comes next, those are the assets already reflecting that valuation.
The performance of the investments is entirely reliant on the skill of the manager and that makes us nervous.
Wesley Coultas, investment director at wealth manager Walker Crips takes this view.
He said: “Buying quality assets cheap with a margin of safety is the essence of defensive investing.
"The UK as a whole looks cheap, and there are quality assets trading at discounts as a result of the Brexit factor.
"Various struggling UK sectors have been trading on price to earnings ratio (P/E’s) unheard of pre-financial crisis.
"Such sectors include UK financials, which saw their prices surge as the UK reached a withdrawal agreement with the EU.
"With greater certainty on Brexit it is likely we will see further gains in UK cyclicals, not only in the financial sector but house builders, retail and telecommunications, which would all benefit from a managed withdrawal.
"Japan also appears cheap as investors remain wary of the viability of Abenomics.”
Alternative defensive assets
He also views prime commercial property as a defensive asset in the current climate.
This is a view echoed by JP Morgan’s Ms Maharaj, who views prime commercial property as a safe haven, as well as Japanese equities, because the Yen as a currency tends to perform well in times of economic stress.
Both of those investors regard infrastructure investments as potential safe havens as well, because the income is guaranteed by the government, but the income received is higher than that available from a government bond.
Mr Elston is skeptical that these investments are truly uncorrelated. He takes the view that the price of those assets has risen starkly in recent years as investors simply search for an alternative source of income with bond yields being low.
He said this means the price of the assets has risen as bond prices have, making them correlated to a wider economic theme, and so arguably less defensive.
House View: What happens to high yield bonds in times of market stress?
The current macroeconomic backdrop is creating challenges for investors.
Global growth is slower and inflation is benign.
Meanwhile, central banks appear to be returning to more accommodative policies and geopolitical tensions have increased.
Downturns in the business cycle, often caused by adverse economic conditions, can lead to a number of trends that are negative for investors in high yield bonds.
For example, some companies may find their credit ratings downgraded, which impacts their ability to borrow and can force some investors to sell their bonds.
There may be a higher number of companies that are struggling to repay the interest on their debts as business conditions become tougher and their sales decline.
There can also be more widespread selling of riskier assets such as high yield bonds as investors look to dial down risk in their portfolios, or react to negative news headlines.
Unsurprisingly, considering the economic backdrop, some investors have become increasingly nervous about taking risk.
Corporate bonds (bonds issued by companies) are rated on a scale by analysts according to the strengths or weaknesses of the company and how risky it is to lend it money (by buying its bonds).
At the highest quality, least risky end is the AAA rating.
Bonds rated AAA, AA, A or BBB are considered investment grade, while bonds rated BB, B, CCC, CC or C are classified as high yield.
High yields bonds are considered riskier and as such will pay a higher level of interest to the bondholder or lender.
However, with higher risk comes potentially attractive investment rewards.
High yield tends to recover quickly and strongly.
The point at which an investment is made clearly plays a significant role in determining returns.
It has often made sense to invest after markets have fallen, when valuations have become lower or cheaper.
This has been the case for high yield corporate bonds, which have demonstrated resilience over time, bouncing back strongly following sell-offs in the market.
Although this backs up the investment adage of “buy the dip” (buying assets after they fall in value), detailed analysis is crucial to identifying such buying opportunities.
The following chart illustrates this rebound effect as exhibited by global high yield during recent periods of market stress.
Prices of shares or bonds, and the income from them, may fall as well as rise and investors may not get the amount originally invested.
This is also clearly demonstrated if we look back to the global financial crisis.
In 2008, the pan-European HY market returned -31 per cent and US high yield returned -26 per cent.
Both then rebounded forcefully the following year, with the pan-European market adding 85 per cent and the US market 58 per cent.
And each made further good gains, in excess of 15 per cent, in 2010.
Strong rebound after 2008 financial crisis
Between the end of 2007 and 2010 the US and pan-European high yield indices returned 34 per cent and 31 per cent respectively, or 10 per cent and 9.5 per cent annualised.
The chart shows total returns. That is changes in the price of the bond plus the yield income paid on the bonds.
The key driver of returns during this period, and indeed over the long-term, is income.
Income drives total returns
While this looks appealing, the higher level of income or interest also reflects the higher level of risk involved.
In particular, there is a higher risk that a high yield company may be unable to make a periodic interest payment.
This is not to say that the yield on the bond will necessarily provide an accurate or fair reflection of the risk.
If the yield is high, it may be exaggerating the risk, in which case the bonds may be particularly appealing.
High yield issuers are often smaller companies in more niche, specialist areas. As such, it is not unusual for yields to move out of sync with company fundamentals.
Companies issuing bonds are obliged by the terms of the ‘bond’ to pay interest and ultimately fully repay bondholders, which is set out in legal documentation.
This is not the case with income on equities, paid in the form of dividends, which are at the discretion of the company’s management and dependent on the company’s performance.
The current global uncertainties certainly call for a circumspect and judicious investment approach.
Investors are right to tread carefully, certainly in relation to riskier asset classes.
However, it also makes sense to keep the unique and sometimes subtler characteristics of different markets in mind when constructing portfolios and making investment decisions.
Jonathan Harris is investment director of fixed income at Schroders