The days when portfolios could be protected by increasing their weighting to bonds are gone. Tom Bailey reviews today’s options.
Over the past year, markets have seen a sea change. Gone are the days of hopeful talk of “global synchronised growth” and the continuation of the bull market; instead, there has been a return to volatility and growing fears of difficult times ahead. In the face of such bearish sentiment, should nervous investors think about returning their portfolios towards more defensive investments? The answer to that question depends to some extent on your timescale.
For younger investors, market slides such as we’ve recently seen should sensibly be viewed as an opportunity – a point forcefully made by financial author William Bernstein in his book The Investor’s Manifesto. “A 25-year-old who is actively saving for retirement should get down on his knees and pray for a decade-long brutal bear market so that he can accumulate stocks cheaply.”
Such advice is based on the assumption that equity prices trend up over the long term, with the average annualised return for the S&P 500 index between 1970 and 2016 being 10%. For millennial investors, should future returns follow past trends, such numbers appear promising.
But for others, for instance those with a short time horizon or using their pension fund to provide an income at retirement, a bear market poses the risk of deep losses with no time for recovery. It’s a reflection of the fact that stock performance is not evenly distributed. The 10% average return is just an average, smoothed over time. For instance, as Howard Marks points out in Mastering the Market Cycle, between 1970 and 2016 the S&P 500 index only provided annual returns within 2% of the 10% average on three occasions. Moreover, Marks notes: “The return had been more than 20 percentage points away from ‘normal’ [10%] – either up more than 30% or down more than 10% – more than one quarter of the time: 13 out of the last 47 years.”
Diversify, diversify, diversify
allocation mantra recommended to private investors. Investing in a range of asset classes has historically provided a degree of protection when stockmarket volatility rears its head, as different regions and asset classes are impacted to different extents, or in some cases (gold, for instance) may even rise in value in such circumstances.
Traditionally, bonds have formed the defensive ballast of a portfolio, but following a multi-decade-long bull market that has sent bond prices high and yields lower (with prices further boosted by ‘loose’ central bank policy over the past decade), the traditional view that bonds will adequately protect investors has been undermined.
As David Thomson, chief investment officer at VWM Wealth, notes: “Fixed-interest investments, which in theory are low-risk, may be much more risky than in the past, as their prices have been inflated by quantitative easing. Consequently, traditional safe havens are currently in short supply.” At the same time, as various market drops in 2018 showed, the low correlation between equities and bonds is far from guaranteed.
With bonds no longer the obvious choice, investors have to cast their nets wider and consider the variety of other defensive investments to protect against market downturns and volatility.
Absolute return funds
Targeted absolute return funds sound attractive, as they aim to deliver positive returns in all market conditions. The funds are an eclectic mix, but all can invest in a wider range of assets than a typical equity or bond fund. Many are able to make use of complex financial instruments such as derivatives, currency hedging and short selling. In theory, these funds should protect against losses in a major market downturn.
But the reality is that over various time periods absolute return funds have disappointed. Last year was a case in point, with only 16 absolute return funds producing a positive return out of a total of 123 funds – equating to just 13%. BlackRock Emerging Markets Absolute Alpha, Natixis H2O MultiReturns, Thesis TM Sanditon European Select, Man GLG UK Absolute Value and Man GLG Alpha Select Alternative were the top performers.
On a slightly longer-term basis, absolute funds also disappoint. According to Alan Steel, founder of advisory firm Alan Steel Asset Management, the most popular absolute return funds over the past five years have been Standard Life Global Absolute Return Strategies (GARS), Invesco Perpetual Global Targeted Returns, Aviva MultiStrategy Targeted Returns and Newton Real Return, all of which have billions of pounds of investors’ money.
Overall, he says: “The performance records of these mega-funds are pretty dire.” He continues: “Three years ago Standard Life GARS was £26.7 billion in size. But now, thanks to its poor performance since then (down 3.4%), investors have been leaving and its assets have almost halved, with just under £14 billion held at the end of 2018.”
Thomson, too, is no fan of absolute return funds. He adds that many were launched following the financial crisis, so have yet to be tested in a serious downturn: “Most of these strategies have not been tested through a very serious setback like the credit crunch – in a similar scenario I think they might struggle, particularly if liquidity dries up in the derivatives markets.”
In contrast, Jason Hollands, managing director at Tilney Bestinvest, notes that absolute return funds, in the latest bout of volatility in the final three months of 2018, appeared to do what they promise: protect against sharp market falls. “The average capital return across the IA targeted absolute return sector was -2.46% during the fourth quarter of 2018 – one of the best-performing IA sectors over this period.” He notes the performance of Standard Life GARS and Invesco Global Targeted Returns – -2.24% and -2.58% in capital returns – describing their losses in the period as “hardly a disaster”.
Flexible funds and trusts
Rather than absolute return funds, various fund analysts suggest that flexible investment trusts focused on capital preservation and cautious multi-asset funds are worth considering.
According to Thomson, a cautious multi-asset fund should be well-diversified and “not trying to be too clever by putting too many eggs in one basket and running the risk of getting things badly wrong”. He adds: “They are the tortoises of the investment world – but as in the fable they can do well.”
Steel concurs, noting: “We prefer long-only uncomplicated cautious funds such as Sebastian Lyon’s Troy Trojan (Lyon also manages Personal Assets investment trust), David Jane’s LF Miton Cautious Multi Asset, or the team running Axa Defensive Distribution. All of these funds have a superior record and less mumbo jumbo.”
Ben Yearsley, director at Shore Financial Planning, is also a fan of Troy Trojan. He says: “I’ve had Troy Trojan in my pension for about 10 years now. I accept it will lag mainstream equity funds in rising markets, but it should outperform in falling markets.”
However, in general he prefers multi-asset investment trusts over cautious multi-asset open-ended funds. He identifies the flexible trust Personal Assets as a particular standout performer in the Association of Investment Companies’ flexible sector.
Thomson argues that other defensive trusts have also done well. He notes that popular flexible trust Capital Gearing has managed to hold up well in the recent sell-off. Moreover, he adds, the true test is that during the credit crunch and Lehman Brothers bankruptcy, Capital Gearing also did “exceptionally well”, actually gaining 13% between October 2008 and March 2009.
Defensives in your portfolio
It’s important to recognise that all three investment types claim to protect capital against volatility to varying degrees. In the recent sell-off, all three types saw only comparatively small drawdowns. However, while investors may be looking to these products for protection against such volatility, unless they manage the impossibility of perfectly timing the market and buying such products just before a drawdown, consideration also needs to be given to how these investments will hold up in the portfolio during better years.
Ideally, defensive investments should be able to capture at least some of the upside of rising markets, as well as providing protection when the bear market inevitably emerges. But the desire to capitalise on stronger markets does mean most people would not want the entirety of their portfolio, or any percentage approaching that, in defensive investments. Instead, defensive investment vehicles should form part of your portfolio (depending on your outlook and appetite for risk), in order to guard against the worst of any downturn.
Absolute return and flexible sectors compared
In general, the AIC flexible sector has produced better performance than the IA absolute return sector over longer time horizons. Over the past three years, the absolute return sector has produced a measly return of 3.3% – which is below inflation – compared with the AIC flexible investment trust sector’s return of 28.6%. On a 10-year basis, the absolute return fund sector has returned 32.1% and flexible trusts 93.6%.