Many portfolios traditionally use government bonds and cash to be defensive. With bond rates and cash rates now at historic lows, there is no longer much yield or return that one can expect from a long-term investment in these. Furthermore, the likelihood of losing money over time in real terms is now higher, given it now requires little inflation to overcome the mediocre expected return from historically low yields. Unfortunately, such a situation reflects lacklustre economies and is the end result of market returns being pulled forward by government intervention. Traditional defensive investments have simply become a tool of government policy as governments attempt to prolong an ‘artificial’ economic expansion. 

Some investors are forced to hold government bonds due to their very nature as institutinoal investors by government policy. Other investors – and many using traditional funds to invest their money - simply hold these assets as a default, their strategic philosophy or simply because of peer risk (managing the risk to the agent, rather than that of the investor). Bonds and equities comprise the bedrock of Strategic Asset Allocation (SAA) portfolios.

Bonds can serve as a useful complement to equities in a downturn, given their negative correlation to equities in recent years and typical market dynamics. An issue here is that given bonds are at the heart of the asset bubbles created by easy money, they may no longer provide such protection in future downturns; indeed, they could even potentially exacerbate the losses from equities in certain circumstances.

Still others hold bonds, not because they believe they are attractively priced, but because they are still speculating on further easing of policy by government in the short term, beyond what is already priced by markets.

Unfortunately, many investors seem to have forgotten rule no 1 of investing for long term survival – managing risk. Expensive pricing of mainstream assets including defensive assets, and the macroeconomic backdrop, argues that investors should – at the very least - be considering alternatives to their traditional narrowly focussed equity and bond portfolios. One option is including genuinely active and liquid alternatives in a portfolio in meaningful weights. This aims to provide relative protection in the event of a market sell-off, yet still offers the prospect of impactful, unrelated and diversifying return streams over time.

One of the costs of being better diversified and including alternatives is less upside in strong markets. However, low return prospects from mainstream assets mean alternative better diversified portfolios don’t have as high a hurdle to beat to be competitive on the return front on a forward-looking basis. Furthermore, such portfolios can serve as an alternative or complement to the traditional portfolio of both equities and bonds, but with the benefit of avoiding the bulk of the pain that a bear market could inflict on these.

  • The best time to invest aggressively is at the start of a cycle when valuations are cheap and economic prospects are enticing i.e. many years ago now! The worst time to invest aggressively is when both valuations and economic risks are high, and yet the market is complacent about these risks and under-pricing them. Only by being different, highly selective and prudent can one currently expect to provide relative capital protection in the event of any large market collapse, a credit crisis or a global recession.

Whatever your philosophy, many would argue that given the incredible position markets find themselves in, true diversification is necessary now to provide protection against the wide unknown. This mandates thinking differently and argues for thoughtful portfolio construction, greater active management and use of liquid alternatives, rather than following the mainstream and being passive in one’s approach while hoping that a rising market will forever lift all boats.

It is also important to be more defensively positioned now given the high valuation levels, late cycle stage of the economic cycle, and increased risk of large market falls should global slowing continue. Steady and continuing Japanification or zombification of the world’s economy is a major continuing issue which requires a major circuit breaker, yet the world is precariously placed politically to instigate structural and fiscal reforms and seems wanting to fight the natural cycle and cleansing effect of a recession.

We are now 11 years in to a global economic expansion following the GFC. The expansion has been prolonged due to massive monetary stimulus, and has been relatively shallow despite massive monetary stimulus. It is getting harder and harder for central banks and governments to continually “kick the can down the road”, although they appear determined to try. Easy money is becoming increasingly ineffective, and dealing with the next recession or crisis will be a formidable challenge for governments.

As interest rates globally have moved to negligible or negative levels, they are increasingly becoming counterproductive to real economic and productivity growth, through mechanisms such as lower confidence, impaired intermediation and banking and less ‘creative destruction’, and through ongoing and increasing capital misallocation. Such policy “mistakes” sow the seeds of their own demise.

Of note, it is now very difficult for investors who want to prudently emphasize the return of their capital in real terms. It is hard to argue there are attractive traditional “defensive” investments, when nearly every mainstream asset class may be in an enormous bubble. Historically, while government bonds and cash provided this role in a portfolio, that benefit was provided from a starting position of much higher yields. With miniscule cash rates, cash is now eating away at one’s principal in real terms over time. Likewise, with low (and in many cases negative) bond rates, which are being heavily suppressed, bonds are at risk of capital losses from any normalisation of yields - or even just normal volatility.

The returns of cash and bonds arguably no longer compensate for their risks and deficiencies, and even normal volatility could render bond returns substantially negative given their lack of sufficient starting yield. Hence, how can one be relatively defensive in future years and yet still achieve a reasonable return using “traditional” defensive investments alone?

In this context, it is interesting to observe the large and optimistic real returns many investors are apparently expecting from their portfolios; these are hardly a realistic return objective for everyone starting from here! In stark contrast, in coming years, any decent positive real return could end up providing a superior return to mainstream investments. This is particularly the case in risk adjusted terms, when the major risk is highly elevated valuations and peak earnings combined with unsustainable and ineffective policy settings.

Advisers with their clients’ interests at heart should consider managing their exposure to valuation and economic risks, and exposing their investors more to risk which is being fairly compensated ex-ante with the prospect of adequate returns. It takes courage to be different from peers, to look forward instead of backward, and is costlier to implement than simply copying what others do! That said, the potential benefits in being genuinely active and different are substantial and include better diversification, better defensiveness, and absolute return expectations which better align with investor expectations. Minimising the client harm from the next crisis is likely to have substantial business benefits for advisers that do. Indeed, it is prudent management of business risk given the stage of the cycle, and provides great client alignment given the age of many clients nearing or in retirement.

One example of how portfolios can be different to provide defence is by turning traditional investing on its head by including shorting (e.g. a manager can short a basket of expensive low-quality assets such as suspected frauds). Another is cherry-picking attractive strategies such as selectively extracting return from merger arbitrage, while yet another is selectively yet meaningfully investing in precious metals. Genuine alpha, or prospective excess risk adjusted returns, is scarce and highly attractive; it can be obtained from careful manager selection and dynamic management, often by investors with moderate scale (such as financial advisers) and willingness to engage appropriate resources to undertake skilled manager selection.

It is very important in these uncertain and difficult times for investors to be diversified, and doing things differently helps avoid crowded trades, hence contributing to this crucial diversification. The sheer scale of government intervention needed to keep markets alive on a daily basis is frightening. Without this government intervention, markets would have collapsed already and entered a classic debt deflation spiral, as massive amounts of capital misallocation and poor credits were exposed and expunged. Importantly, this may simply be an issue of timing i.e. is this market cycle really different, or simply delayed by intervention?

Importantly, despite the reassurances of the always overly optimistic, there is no guarantee that the seeming status quo of strong equity and bond markets will continue (it is human nature to be an optimistic, which is perhaps why so many eventually fail when investing - given it is better for this purpose to be a flexible realist!). No one knows for sure where the extraordinary conditions we find ourselves in globally will end up, but one might reasonably hold the view that the regime we are currently in will have to pass and change, as it becomes increasingly unstable and hard to maintain. Such a change would prove highly problematic to the unprepared, if not outright scary.

The only way to get a different result from the mainstream is to be genuinely different, and the only way to protect capital other than through luck, is to recognise what the big risks truly are and then address these in a meaningful way. The next few years are likely to be very different from the last few years; risk management will be key. Hence, being more defensive, minimising the overarching risks, and risk-managing dependency on general market outcomes may become absolutely essential. This includes the need to reconsider both traditional defensive and growth asset allocations, what reasonable expectations from these are, and their competitiveness with other options. Adapting to current markets with a more dynamic approach which uses genuine liquid alternatives offers several benefits to clients and to advisers’ businesses. It could easily prove immensely beneficial in providing relative capital protection when and if markets fall, and particularly so if we enter a global recession, another credit or financial crisis, or there is widespread recognition of policy failure on the part of major governments.  



Matthew Walker

Clear, succinct and rationale...thanks for the insights Jerome.