A guide to ‘defensification’

John Stopford and Jason Borbora of Investec Diversified Income Fund reflect on how investors can protect themselves against the risk of a market sell-off now.

Why be defensive?

Reading the signs of financial markets is always difficult, and the market environment today makes for a particularly tough analysis. 
Buoyed by unorthodox central bank stimulus, many stock markets have risen to expensive levels while investors have been drawn into riskier and higher yielding bonds in their hunt for income.

Despite the absence of asset price volatility, investor concerns are rising. How should they protect against the risk of a market sell-off now that this bull market is one of the longest on record?

Investors are right to be wary as avoiding significant losses can materially impact performance. Over the last 20 years, for example, an investor in the FTSE All Share who missed just the worst five months of performance would have beaten the index by over 600% (source: Investec Asset Management, Bloomberg, June 2017).

‘The best offence is a good defence’

At Investec Asset Management, we believe the key to good investment defense lies in looking beyond the traditional, simplistic ‘top-down’ approach to portfolio construction that many investors adopt.

To us, the characteristics of an asset class matter much more than its ‘equity’, ‘bond’ or ‘alternative’ label. Instead of focusing on traditional asset allocation, or holding a fixed proportion of bonds, equities and other asset classes in a portfolio, we choose to place a greater emphasis on understanding an investment’s ‘true’ behaviour and its relationship with the economic cycle.  

In doing this, we seek to construct a portfolio that is genuinely diversified across a range of assets with growth, defensive and uncorrelated characteristics.    

Moreover, by investing only in securities with sustainable income streams and capital growth potential, we believe we can build a portfolio better able to handle episodes of market weakness and reduce the severity of drawdowns.

Finally, a clear focus on downside risk management recognises that negative events can occur at any time, making it prudent to scale back exposure to try to limit their effects.

These three layers of portfolio design underpin the objectives* of the Investec Diversified Income Fund.

Investec Diversified Income Fund Aims*

*Performance targets may not necessarily be achieved and are not guaranteed, losses may be made.

“A defensive approach starts with a genuine understanding of the resilience of the cash flows supporting the dividends and coupons paid by individual securities”

John Stopford, Jason Borbora, Portfolio Managers, Investec Diversified Income Fund

Diversification versus ‘defensification’

Within equities, for example, the perception that a company’s high dividend yield is a guide to its likely returns is erroneous. Simply because a company is paying out a high proportion of its earnings does not mean this is sustainable. What if the company is in distress or investors are forcing down the share price in anticipation of a dividend cut?

Similarly, high yields on sub-investment grade corporate bonds or emerging market debt may simply be warning of the risk of default.

Chasing yield without taking account of the accompanying risks can lead to painful capital drawdowns that far outweigh the level of income offered; often an asset offers a high yield because of the proportionately higher risks it presents. A bottom-up approach seeks to understand the sustainability as well as the level of an investment's income stream in addition to its potential for capital appreciation. Take sub-investment grade corporate debt as an example. Those at the bottom of the credit rating spectrum, where the average yield over the past 10 years has been nearly double that of their more highly rated peers, suffered a drawdown in 2008/09 of nearly 20 percentage points more than less risky BBB/BB rated issues. Similarly, equities with the highest dividend yields underperformed the broader stock market during the financial crisis. A top-down approach may be able to achieve yield but it may come at the expense of resilience and capital.

Source: Bloomberg, Investec Asset Management, May 2017

Investec Diversified Income Fund: A portfolio beyond diversification

A more defensive approach looks beyond simple diversification and the top-line yield offered by assets. Rather it requires a genuine understanding of the resilience of the cash flows supporting the dividends and coupons paid by individual securities. By looking at measures such as profitability, the stability of cash generation, the debt burden and how much flexibility there is to deal with a changing economic environment, we aim to reduce the impact of drawdowns on the portfolio and improve investors’ probability of meeting their goals over long-term periods.

Issued by Investec

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income.

Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.

Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss.

Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss.

Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed.

Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises.
Multi-asset investment: The portfolio is subject to possible financial losses in multiple markets and may underperform more focused portfolios. 

Bond and Multi-asset funds may invest more than 35% of their assets in securities issued or guaranteed by an EEA state.