A Guide to
For Financial Advisors Only
WHY BE DEFENSIVE?
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
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.
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
Targets 4%-6% per annum
Income and capital growth
*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
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
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
“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/
Source: Bloomberg, Investec Asset Management, May 2017
MSCI World high dividend yield
Emerging market debt
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.
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”
Senior Investment Manager,
STRUCTURALLY DIVERSIFYING SOURCES OF RISK
“We believe a characteristic-focused approach to asset allocation avoids the need for market timing or overtrading when high levels of market stress cause asset class correlations in a portfolio to rise”
Percentage return over equity drawdown across different labels
(with similar characteristics)
What lies beneath
Holding assets which exhibit different return patterns provides the potential to build a portfolio that delivers a superior trade-off between risk and return. This is the concept of diversification. Problems occur, however, when diversification is improperly implemented (often when based on labels rather than behaviours) or when it is done just to reduce risk without also focusing on whether each additional position can also add to potential returns.
For example, a portfolio invested in equities, high yield corporate bonds, convertible debt and real estate may appear on the surface to be diversified, with each asset sounding very different from the other. The reality however is very different because these securities may have different labels but they exhibit similar relationships to the economic cycle and so are susceptible to delivering negative performance at the same time, rather than providing the offsetting returns one would hope for from true diversification.
Source: Morningstar, Bloomberg, BofA Merrill Lynch, Investec Asset Management. Drawdown from May 2015 to equity low of February 2016. Global Equity: MSCI World; High Yield Bonds: BofAML Original High Yield; Convertibles: BofA Merrill Lynch Global 300 Convertible; Listed Property: FTSE ERPA/NAREIT developed.
Looks beyond labels
Only holds exposures which are expected to add to performance, rather than just spread risk
Maintains a mix of asset types which evolves with the cycle
Diversifies sources of income
To achieve ‘true’ diversification we take a different approach that:
Beyond asset labels
We divide assets into three groups: Growth, Defensive, and Uncorrelated according to how their returns are impacted by the economic cycle. Determining any given asset's classification relies on undertaking a quantitative and qualitative analysis of its behaviour relative to others. Below we give some commonly encountered examples of these. Above all though, to be used effectively, these classifications require an understanding beyond historical relationships and an anticipation of future trends.
Certain asset classes are little affected by the economic cycle and therefore behave in an Uncorrelated fashion with Growth and Defensive assets. These assets offer the potential to increase portfolio returns without adding to risk and so are very useful, particularly for defensively minded investors.
Given the lure of yield for investors of recent times, finding genuinely Uncorrelated assets with secure and attractive income streams are rare. Infrastructure investments, the cashflows of which are frequently backed by very long-dated government funding, have traditionally represented such an investment, however, considerations of valuation and liquidity must be made when selecting such investments.
By contrast, investments which have inverse relationships with the economic cycle offer Defensive properties, which can offset negative returns on Growth assets. These tend to deliver better returns in more difficult economic conditions. Currently we classify safe-haven currencies such as the Yen as defensive, and whilst we still see high quality developed market sovereign bonds as offering such properties, an analysis of their return drivers has caused us to place less reliance on them as Defensive assets.
These assets are positively correlated with the health of the global economy, being reliant on periods of economic expansion often for earnings potential or for spurring risk-seeking behaviour from investors. Consequently, we classify both shares and high yield corporate bonds as Growth assets rather than thinking of them as equities and fixed income. Other examples include property, and unhedged EM debt.
Smoother return profile
Holding assets which exhibit truly diversified returns will offset the volatility of each individual holding in the portfolio and produce a smoother set of returns from it.
Less reliance on market timing
A characteristic-focused approach reduces the need for trading should high levels of market stress cause correlations in a superficially diversified portfolio to rise. This would need to be corrected by selling existing positions to guard against losses, allowing investors to consistently collect a coupon or dividend payment from their positions.
Prepared for the unexpected
Risky assets tend to experience their most significant losses in recessions which typically represent a small period of any economic cycle. This is not to say however that significant losses cannot occur outside of recessions. A truly diversified portfolio keeps investors on guard for the significant drawdowns that can occur due to non-cyclical events.
How this helps defensification
Another aspect of risk for a defensive strategy to consider is how concentrated sources of income in a portfolio are; it is not uncommon to see investors in some areas beholden to certain sectoral and regional factors in their hunt for it.
To ensure a smoother and more sustainable flow of income, the investment team aims to diversify risk from a yield perspective too.
The composition of the Investec Diversified Income Fund’s yield output, as seen in the chart below, reveals the result of diversifying across Growth/Defensive/Uncorrelated assets and by sources of risk within them. The Fund has been able to reduce risk and produce a less concentrated income stream, while maintaining its target yield requirement. One notable feature of the Fund’s income stream compared to peers is the focus on natural income generation – from the coupons and dividends of its holdings.
Composition of the Investec Diversified Income Fund's yield
suited to the cycle
A mix of asset types
For the majority of an economic cycle (c.70% by time) Growth assets will provide positive excess returns, compensating investors for the uncertainty of owning assets reliant on economic growth for their returns. This means that investors, on average, should weight their portfolio risk more towards Growth assets while also maintaining at all times a blend of Defensive and Uncorrelated assets. This is for the two reasons given above, but also because reading the economic cycle is a very difficult thing to do and holding a mix of asset behaviours guards against one’s read being wrong. As the cycle matures the weighting to Defensive and Uncorrelated assets should increase, recognising that the economic growth engine may start to fail.
Skew not correlation
The correlation of a fund with an investor’s domestic index is increasingly being used as a primary determinant of the suitability of an investment. But simple correlation figures are only good at providing a ‘quick and dirty’ appraisal of an asset or strategy’s characteristics.
Take perhaps the ultimate investment: a strategy that captured all of the FTSE 100’s positive returns but none of its losses over the past 20 years. A desirable outcome, but the portfolio would still have been 80%-plus correlated to the index – a very high number. Yet this investment only exhibits correlation on the upside, not the downside. The correlation figure misses this fact.
As a result we view correlation as something of a blunt measure. It reveals the degree to which on average two assets move relative to one another but nothing about whether they move together, more to the upside or downside (commonly known as skew) or if the relationship between assets changes at different points in the economic
cycle. We seek instead to maximise the potential to capture upside
whilst minimising exposure to the downside. This is the result of our
multi-layered approach to portfolio construction.
“Building from the bottom-up emphasises both the risk and return characteristics that each holding brings to the mix. It also stresses the importance of structural diversification and active management, as well as a focus on limiting drawdowns”
Portfolio Manager, Investec Diversified Income Fund
Charges are taken from capital and may constrain future growth. The amount of income may rise or fall.
Source: Investec Asset Management 30.09.17. The yield reflects the amount that may be distributed over the next 12 months as a percentage of the Fund’s net asset value per share, as at the date shown, based on a snapshot of the portfolio on that day. Where there is a yield number in brackets, it is calculated in the same way, however, as the charges of the share class are deducted from capital rather than income, it shows the level of yield had these charges been deducted from income. This has the effect of increasing the income payable whilst reducing capital to an equivalent extent. Yields do not include any preliminary charge and investors may be subject to tax on their distributions.
Current portfolio yield
A loss of 20%
requires a 25% return to recover;
while a 50% drawdown (as seen in 2008 and 2009)
while a 50% drawdown (as seen in 2008 and 2009) requires a 100% increase to recover the loss back.
A defensive approach, focused on drawdown
The global financial crisis and years of monetary experiments by the world’s central banks have had a profound effect on yield: income is harder to come by and investors are required to take on more risk to find it.
Moreover despite the last few years having eventually produced decent total returns, the lower income offered by asset classes has at times been completely offset by the relatively larger capital losses they have experienced during periods of drawdown.
Reducing risk to protect the portfolio from drawdowns is a primary focus of the Investec Diversified Income Fund. Doing so allows the fund to minimise losses and so compound positive returns.
Required gain to cover loss
Drawdown refers to the peak-to-trough decline of an investment and is an important risk metric allowing investors to assess the downside risk and the ‘upside’ required to reverse it. The ‘law of numbers’ allows us to illustrate the importance of avoiding losses by showing that a loss of 25% requires a 33% return to recover it. Meanwhile, a 50% drawdown - as seen in markets between 2008 and 2009 - requires 100% increase to recover that loss back to zero.
The possible impact of future events should be thought about. If these events (for example geopolitical tensions or referendums) are determined to have a significant likely impact on the portfolio, and their probability is uncertain but material, then exposure to these can be partly hedged out to reduce unrewarded volatility.
Investors should monitor the market environment for signs of increased risk and when this occurs they should reduce market exposure even if this means sacrificing short term gains. This decision should be based on a combination of quantitative and qualitative analysis.
Amid today’s low yield environment, stretched asset class valuations, and rising geopolitical and monetary policy risks, it is important that the method of how and when to shift the focus towards downside protection is consistent, practical and reliable.
We believe portfolio risk should occasionally be dialled down temporarily for two reasons.
be dialled down?
When should portfolio risk
Stress testing: Prepare for the worst and respond quickly
Stress testing against both of the above provides us with an understanding of the upside or downside risks of our positions. As financial market stress or event risks develop, the risks to drawdowns are heightened, reducing the attractiveness of the risk/reward environment. In such situations, the risk taken by the strategy can be ‘reigned in’.
By monitoring both such risks systematically, we can scale down risk to temporarily protect the portfolio. Having built the portfolio with a thorough understanding of the risks of individual positions, this can be done with greater efficiency and precision.
Risk statistics vs. income and defensive competitors
Performance over 10 worst days for equities
Performance of DIF vs. gilts on the 10 worst days for bonds
(price change in bond index)
Performance of Diversified Income Fund vs. every negative monthly equity return
Multi-layered management of risk
“Since inception, the Fund has been able to outperform both gilts and global equities during every single one of their respective worst days of performance”
Portfolio Manager, Investec Diversified Income Fund
Portfolio structure, position selection and tactical risk management all help to limit drawdown. The net result of consistently applying these principles helps to produce a strategy with better risk-adjusted returns, ultimately aiming to deliver on the fund’ return objective for investors.
Considering the current yield environment, stretched asset class valuations, and rising geopolitical/monetary policy risks makes this drawdown focus particularly important.
By taking an approach which seeks to capture returns to the upside and guard against the downside, the Investec Diversified Income Fund has been able to skew the returns in a positive direction and compound returns in challenging markets, as can be seen in the chart below.
Similarly, and by again ensuring a portfolio is not reliant on just one source of returns, the Diversified Income Fund has shown how, even in the very worst instances of market distress, it can withstand bouts of high volatility and minimise losses. Since inception, the Fund been able to outperform both gilts and global equities during every single one of their respective worst days of performance. These are very short time periods and so not something the fund would explicitly seek to achieve. nevertheless, it is very difficult to predict when any single day of losses might occur and so this is a decent
demonstration of how the fund’s natural set-up is defensive.
Aside from bottom-up resilience and structural diversification of a portfolio, which we have discussed in this eBook previously, there are a host of tools available to control risk during periods of market weakness. Selling equity futures to reduce equity market exposure, buying or selling bond futures to adjust duration, and hedging currency exposure using forward foreign currency contracts are all liquid and scalable methods of controlling risk when the market environment shows signs of deteriorating. But these tools’ efficiency is only maximised when applied to a portfolio whose risk exposure is also appreciated.
This is why the Diversified Income Fund places risk management at the core of its strategy. By building a portfolio from the bottom-up, rather than through blunt blocks of beta, thereby achieving ‘true’ diversification of risk and income, the Fund aims to provide a defensive stance in all market scenarios.
The result of implementing this approach since the fund launched in September 2012 has been positive. The Fund has outperformed the MSCI World Index in all but two of its 18 negative return months since 2012. In fact, the Fund produced positive returns in half of the index’s negative periods as a result of individual securities in the portfolio frequently outperforming.
1 month % change of MSCI World US$
1 month % change of Investec Diversified Income
Source: Morningstar, 31.10.17, based on NAV to NAV (inclusive of all annual management fees but excluding any initial charges) of I Acc, monthly data, gross income reinvested, in GBP. Structural diversification.
Past performance should not be taken as a guide to the future, losses may be made.
1 day change of UK benchmark 10 year DS. Govt. Index
1 day change of Investec Diversified Income
1 day change of MSCI World US$
Source: Morningstar, 31.10.17, based on NAV to NAV (inclusive of all annual management fees but excluding any initial charges) of I Acc, monthly data, gross income reinvested, in GBP.
*Source: Morningstar, 30 September 2017, NAV based, gross of UK basic rate tax (inclusive of all annual management fees but excluding any initial charges), in Pound Sterling. Retail share class net performance in GBP since inception: 3 September 2012. UK Equities = FTSE All Share TR GBP.
The list of competitors is frequently reviewed and is based on our Multi-Asset team’s analysis of the competitor landscape. The defensive peer group average is based on all multi-asset funds within the IA Targeted Absolute Return sector. The income peer group average is based on all funds from within the IA mixed Investment 0-35, 20-60, 40-85 shares and specialist sectors
which include ‘income’ and/or ‘distribution’ in their fund names and are over £100m in size.
Past performance is not a reliable indicator of future results, losses may be made.
FTSE AllShare TR GBP
Max drawdown average
Up/down ratio average
Standard deviation (annualised)
Investec Diversified Income
The challenge of generating a high and sustainable investment income while simultaneously protecting investor capital has never been more difficult.
Thus, defensification is a powerful fund attribute at a time when asset class returns appear slim, providing the managers of the Investec Diversified Income Fund with a number of tools to not only help them control downside risks from the outset, but to maintain low volatility as well.
Though it may go against traditional multi-asset investing norms, by building from the bottom-up and diversifying the assets we invest in by their behaviours rather than labels, the team is able to place ‘defence’ at the heart of the strategy and properly stress-test portfolios against a variety of market environments.
The last 5 years, despite producing impressive overall returns, has seen some challenging market performance at varying points and across asset classes. August 2014 to January 2016 saw a 30% drawdown in Emerging Market Local Currency debt, May 2015 to February 2016 saw a near 20% drawdown in global equity markets, and US treasuries saw a 6% drawdown from April to August 2013.
Against this background, the net result of consistently applying defensive principles has seen the Investec Diversified Income Fund deliver a resilient and better diversified portfolio that has delivered its target yield of between 4%-6%,with the lowest drawdown* versus its peers and the FTSE All Share Index, as can be seen in the chart above. Going forward, by taking an approach that continually looks to guard against downside risks, we anticipate the fund’s lower-volatility and outcome-focused strategy will have the potential to continue to perform in challenging markets.
1 Source total return: Morningstar, dates to 30.11.17. Source fund performance: Morningstar, 5 years ending December 2016. Performance is net of fees (I Share class, NAV based, including ongoing charges, excluding initial charges), gross income reinvested (net of basic rate UK basic rate tax pre 5 April 2016), in GBP. If the share class currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Since inception: 3 September 2012, prior to this date, the fund was called Managed Distribution, and was managed to a different investment objective.
2 Yields quoted are for the I Inc-2 share class of the Fund. The yield reflects the amount that may be distributed over the next 12 months as a percentage of the Fund’s net asset value per share, as at the date shown, based on a snapshot of the portfolio on that day. Where there is a yield number in brackets, it is calculated in the same way, however, as the charges of the share class are deducted from capital rather than income, it shows the level of yield had these charges been deducted from income. This has the effect of increasing the income payable whilst reducing capital to an equivalent extent. Yields do not include any preliminary charge and investors may be subject to tax on their distributions.
*Performance targets may not necessarily be achieved and are not guaranteed, losses may be made.