A Guide to Defensification - Chapter 2

For Financial Advisors Only

Structurally diversifying sources of risk

Chapter Two

A Guide to

Defensification

“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”

John Stopford, Jason Borbora Portfolio Managers, Investec Diversified Income Fund

diversification?

‘true’

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.

Percentage return over equity drawdown across different labels (with similar characteristics)

Listed Property

Convertibles

High Yield Corporate Bonds

Global Equity

-14.1%

-11.3%

-10.8%

-16.6%

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.

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

Looks beyond labels

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.

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Growth

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.

Defensive

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.

Uncorrelated

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.

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.

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

Prepared for the unexpected

How this helps defensification

Composition of the Investec Diversified Income Fund's yield

Income diversification

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.

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.

Tap 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.

John Stopford Portfolio Manager, Investec Diversified Income Fund

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”

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.

Portfolio

EM Sovereign Debt

Property

Infrastructure

Equities

HY Corporate Bonds

IG Corporate Bonds

Current portfolio yield

Uncorrelated

Defensive

Growth

DM Gov't Bonds