For Financial Advisors Only
Why be
defensive?
Chapter One
A Guide to
Defensification
peaceful
place to be’
‘A bull market
is seldom a
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
a good
defence’
‘The best
offence is
At Investec Asset Management, we believe the key to good investment defence 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.
Why?
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 try to limit their effects.
These three layers of portfolio design underpin the objectives of the Investec Diversified Income Fund to deliver an income of between 4%-6% per annum*, with scope for capital growth and ‘bond-like’ volatility – which we define as less than half that of UK equities.
Investec Diversified Income Fund Aims
Less than half the volatility of UK equities
Bond-like volatility
Targets 4%-6% per annum
Attractive yield
Income and capital growth
Defensive return
*Performance targets may not necessarily be achieved and are not guaranteed, losses may be made.
These internal parameters are subject to change not necessarily with prior notification to shareholders.
Why being defensive
requires more than diversification
Investments are often made in the hope of achieving diversification. However, in many instances they can end up having the effect of doing little - if anything - to reduce the overall risk. Instead, they merely increase trading costs and erode the portfolio manager’s conviction in their portfolios.
Implementing Defensification: Equity case study
Jason Borbora, portfolio manager on the Investec Diversified Income Fund, explains how Defensification worked in practice when it invested in Cobham plc
‘Defensification’
Diversification versus
The Diversified Income Fund aims to provide a defensive return made up of an attractive level of income, as well as capital growth over the medium-term. The best way to achieve this consistently, we believe, is through the proper implementation of what we have termed ‘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.
Maximum drawdown over 10 years
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. This involves 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.
Those securities we identify as providing attractive, sustainable income with potential for capital appreciation are used to build a holistic portfolio with a mix of different exposures capable of achieving our investment objectives. The composition of the fund is actively managed, with no reference to any benchmark, to reflect changes to the economic backdrop, the risk environment and the on-going desirability of each holding.
By taking these decisions, we aim to reduce the impact of drawdowns on the portfolio and improve investors’ probability of meeting their goals over long-term periods.
*Cash deposits and developed government bonds, have in the past, been generally considered more secure investments than some of the other asset classes held in the Fund, e.g. equities.
A new alternative:
How can Investors use the Investec Diversified Income Fund?
Its aim of providing attractive, sustainable income, with limited drawdown, makes it ideal within a retirement portfolio
Income orientated
The Fund replaces developed, government and strategic bond funds and cash as a source of income
Replacement for bonds*
The Fund’s reduced volatility and outcome focus means asset allocators can place it in the alternatives space
Alternative allocation
“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
EM Sovereign debt (local, USD)
EM Sovereign debt (local, hedged)
Global high yield (CCC)
Global high yield BBB/
BB only
Source: Bloomberg, Investec Asset Management, May 2017
MSCI World
MSCI World high dividend yield
MSCI World
quality
Emerging market debt
High yield
Equities
-22%
-4%
-49%
-31%
-62%
-57%
-47%
Click here to find out more about the Investec Diversified Income Fund
This communication is being provided for informational purposes for discussion with institutional investors and financial advisors only. Circulation must be restricted accordingly. Nothing herein should be construed as an offer to enter into any contract, investment advice, a recommendation of any kind, a solicitation of clients, or an offer to invest in any particular fund, product, investment vehicle or derivative.
The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. Past performance is not a reliable indicator of future results.
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.
“Yield is very important but in addition to that, the fact we can invest into the Investec Diversified Income Fund and keep volatility very low is one of its key attractions”
Jeremy Robinson
Senior Investment Manager,
Charles Stanley