In the coming years, government bonds may not be the right defensive asset for protecting investment portfolios. Investors should consider and understand the characteristics of a variety of defensive assets in order to meet their objectives. Alongside geopolitical uncertainty and record-low bond yields, today’s investors are experiencing risk related to tax cuts, increased infrastructure spending, rebounding energy prices, a tight labor market, and the shift from deflation to reflation. Investors may consider a variety of defensive assets to address the components of equity risk, bond risk and inflation risk. Unfortunately there is no “one-size-fits-all” option. Rather, the right approach is likely a combination of the following strategies that address the mix of risk factors underlying a portfolio today.   Convertible bonds: This is a relatively small asset class that is often overlooked. Their hybrid structure means they can provide upside capital appreciation similar to that of equities, while maintaining the downside protection of fixed income assets. That said, much of the market is unrated, so investors should research credit quality and default risk before buying. Low-volatility equities: Diversifying some equity risk to low-volatility equities can provide some downside protection. This category includes not only minimum-variance strategies, but also quality strategies and variable-beta strategies where managers have the flexibility to move from equities to fixed income, cash or even gold. Tail-risk strategies: While the above are useful, neither will protect in an extreme scenario. Tail-risk hedging strategies are specifically designed to enhance returns during a tail-risk event. As such, they provide no participation on the upside. Under normal market conditions these strategies can be a drag to a portfolio’s return, but they do free up liquidity to buy assets at distressed prices immediately after a tail risk event. Structured equities:   This encompasses tailored and complex1 solutions to help reshape the risk-and-return profile of equity allocations. Though they come with governance considerations, structured equities provide great flexibility in terms of the range of profit and the risk minimization outcomes that can be put into place. Looking at the credit crisis, structured equities did a very good job of limiting the impact of the worst months, but capped returns in the best months. The tail-risk approach is perhaps the most compelling in light of its negative correlation to the S&P 500. However, in reality, none of the above individually will provide the perfect outcome. Combining them is the best way to achieve the desired risk balance under different market conditions. Looking back at 1990, when equity markets produced a positive return, we see that a defensive hedge fund index also returned a positive return 70 percent of the time, albeit not capturing all of the upside. When equity markets fell, the defensive index was up 54 percent of the time. That represents a significant reduction in volatility— without sacrificing return. Defensive Fixed Income   Absolute-return fixed income can also be a useful diversifier within a fixed-income portfolio. These strategies look to achieve positive returns in all market conditions, including when credit spreads widen and interest rates rise. They are less dependent on the fixed income markets and more dependent on manager skill. Interestingly, good funds will be highly correlated during periods when the market or risk assets are doing well, but lowly correlated when growth assets are doing poorly. This type of strategy looks for around two to four percent gross return, but with a volatility of around three to six percent. They are generally liquid and can be easily incorporated into a portfolio. Thus investors who are concerned about the impact of rising yields should consider this type of strategy. Growth Fixed Income   With monetary policy driving yields to record lows and liquidity being withdrawn from the markets, banks are less able to provide credit facility in certain areas. This translates to a good opportunity for longer-term investors to step in and be providers of capital. How much is this worth from an investor’s perspective? For a triple-A secured credit, you can pick up around 75 basis points over the requisite liquid credit. Within the lower levels of investment-grade credit, you can pick up 300 basis points. In addition, many of these investments are based on floating rates, so they can be considered less sensitive to interest-rate risk. Private Markets   An allocation to private markets helps diversify the equity risk premium that exists in many client portfolios. In an environment of heightened inflation, real assets— energy-oriented commodity funds, opportunistic real estate or infrastructure—can provide a high degree of protection. In addition, similar to secured credit, much senior private debt is floating-rate, as opposed to fixed rate. Client Examples   The following examples of an endowment client and an individual-savings client illustrates how we bring the above concepts to bear. An endowment’s predominant objective is to meet its mission, which is often strongly dependent on its ability to meet annual spending requirements—any permanent loss of capital will affect the mission. Headline risk is also a critical consideration. This $200 million endowment was looking for a return of CPI plus four percent. With an unconstrained mandate, the client was able to allocate funds to asset classes with higher long-term expected returns, most notably private equity. Their allocation to real estate and infrastructure is also sizable, at 25 percent. Their hedge-fund allocation provides a bit of additional diversification, but the overall portfolio remains relatively liquid.   Turning to an individual’s savings as another example, it’s important to think about the individual’s age. A younger investor wishes to maximize returns, while those approaching retirement are concerned with transitioning from a return-seeking portfolio to a combination return-seeking/income-oriented portfolio.   The accumulation portfolio aims for cash plus 3.5 to four percent, so we see confidence in long-term investments in equities, embracing some of our ideas around global equity constructions of small cap and emerging markets. Property and infrastructure are also brought in, in the form of listed global property and listed infrastructure. The whole portfolio remains very liquid, with low fees. The retirement portfolio, by contrast, focuses more on capital preservation and aims for cash plus two percent. We again see the principles discussed above in action, such as low volatility in terms of risk management and some allocation to diversifying equity risk in the form of absolute-return fixed income. Takeaways   Historical relationships between asset classes may not prevail going forward. We would like to challenge investors to question the status quo and stress-test their portfolios against multiple economic scenarios. In addition, investors should proactively review their investment guidelines and consider adding more flexibility in order to capture market opportunities or protect against risks. In times of crisis, preventive measures generally fare better than reactive solutions, transitioning from a return-seeking portfolio to a combination return-seeking/income-oriented portfolio.    

Ivan Cheng | 21 Dec 2017

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