This article originally appeared in IMAP.
Brendan Paul (Atrium Investment Management), David Berthon-Jones (Aequitas Investment Partners), and Michael Frearson (Real Asset Management) explain their approaches to constructing the defensive part of the portfolio.
When looking at the defensive side of a portfolio, David Berthon-Jones, CFA — Joint Chief Investment Officer at Aequitas Investment Partners — believes that in the current environment, with inflation receding and interest rates peaking, the 4.2 per cent yield investors can get with Australian government bonds looks particularly attractive.
“I don’t think we need to make the defensive playbook as complex or creative as we did in the decade post-GFC, where yields were around zero. Instead, we can expect in the post-COVID environment, a negative correlation between stocks and bonds will prevail,” says David. “So, we think an allocation to the likes of cash, investment grade credit, and government bonds will be incredibly important for portfolios, regardless of what’s happening in the economic cycle.”
“I don’t think we need to make the defensive playbook as complex or creative as we did in the decade post-GFC, where yields were around zero. Instead, we can expect in the post-COVID environment, a negative correlation between stocks and bonds will prevail.”
-David Berthon-Jones, CFA
Building the defensive part
Also speaking at the 2023 IMAP Independent Thought Conference in Melbourne, Brendan Paul — Senior Portfolio Manager, Co-head of Multi Asset at Atrium Investment Management — believes that when it comes to constructing the defensive part of a portfolio, it’s important to have a risk targeted investment philosophy.
Risk targeted investing is a dynamic approach to generating investment returns in a more consistent manner, while controlling overall portfolio risk. As part of this approach, Atrium uses a rolling three-year risk target for its multi-asset portfolios, which helps to maximise returns for the level of risk taken.
For its portfolio construction process, Atrium uses three investment buckets to help drive returns: ‘growth’ (equities), ‘diversifiers’ (absolute return strategies), and ‘preservers’ (cash, high grade credit, and government bonds).
“The way we think about building the defensive part of a portfolio is by determining how the ‘diversifiers’ bucket and the ‘preservers’ bucket interact with each other, particularly in terms of any structural change in the correlation between bonds and equities,” says Brendan.
“Because we are concerned about risk and capital preservation, we build portfolios that try and achieve a solid outcome. So, for the defensive part of the portfolio, we want both the ‘diversifiers’ and ‘preservers’ to be robust to attain their correlation, which is achieved through the interaction between our absolute return strategies and our preservers.”
According to Michael Frearson, CFA — Director, Head of Fixed Income at Real Asset Management (RAM) — the challenge for RAM in running its diversified income portfolio within a managed accounts structure is to provide a defensive solution for clients that provides regular income and low levels of capital risk.
RAM aims to achieve that by using a barbell strategy — an investment concept that aims to strike a balance between reward and risk by investing in the two extremes of high-risk and no-risk assets, while avoiding middle-of-the-road choices.
As part of this barbell strategy, RAM invests in ASX-listed hybrids, but it also blends that with ETFs to provide some high quality floating rate investment grade exposure, as well as fixed rate government bond exposure.
“That approach generally dampens the risk in the portfolio, while still allowing us to achieve the investment objective,” says Michael. “In terms of the managed account structure, there are limitations in what we can buy, whilst trying to keep costs down and also helping to stabilise the overall portfolio overcome.
“Generally, ETFs provide good sub-sector beta exposure across a range of sectors. This enables us to get some government bond exposure, floating rate senior credit, and also some floating rate sub-debt in the portfolio.”
“Generally, ETFs provide good sub-sector beta exposure across a range of sectors. This enables us to get some government bond exposure, floating rate senior credit, and also some floating rate sub-debt in the portfolio. “
-Michael Frearson, CFA
Overcoming structural issues
David accepts that, at times, there are structural impediments to getting the strategies Atrium wants within certain asset classes, including within the managed accounts structure. And while he says this can be an issue, particularly with alternatives, he believes there are enough liquid, low cost portfolio diversifying options available in the market.
Brendan agrees, adding that sourcing the right investment solutions for clients in a managed accounts structure can be a challenge. Despite this, well structured and diversified liquid alternatives strategies are critical to Atrium’s portfolio construction process.
“We look offshore for vehicles and funds that are not available in Australia. To accommodate that, we’ve created some feeder vehicles that are available on platform for our managed account clients. That gives them access to managers that wouldn’t ordinarily be available in Australia. We also help manage the liquidity situation for those clients through these feeder vehicles.”
We look offshore for vehicles and funds that are not available in Australia. To accommodate that, we’ve created some feeder vehicles that are available on platform for our managed account clients. That gives them access to managers that wouldn’t ordinarily be available in Australia. We also help manage the liquidity situation for those clients through these feeder vehicles.”
A role for property
Although not traditionally considered a defensive asset, David accepts there is a role for property as a defensive play within a portfolio. He believes property, particularly premium commercial property, does provide some defensive characteristics and interesting opportunities in a diversified portfolio.
At Atrium, property falls into the manager’s ‘diversification’ bucket. However, Brendan cautions that with property: you need to understand the verticals you’re looking at; what type of risks you’re taking in that part of the portfolio; and whether they are correlated to other risks you already have in parts of your portfolio.
“For this reason, we’ve been avoiding commercial/office for a while in our real estate portfolio. There are also liquidity issues to be aware of. You want to make sure that the structures you’re going into have liquidity that match the liquidity of the underlying assets,” he says.
However, Michael doesn’t believe property can be considered a defensive asset.
“If you’re structuring the defensive part of a portfolio, there are many more defensive assets you can include — like cash, bank bills, investment grade credit, and government bonds. You can blend these together in a diversified portfolio to provide the defensive part of the portfolio,” he says.
“From a portfolio construction perspective, we’re aware of the qualities of having foreign currencies in portfolios and the diversification benefits they can provide. We have a reasonable foreign currency allocation because of its defensive qualities.”
Currency as a defensive play
David believes currency plays an important role as part of a portfolio’s defensive allocation. He says when it comes to currency, advisers will either completely hedge or unhedge the international equities component of the portfolio.
“So, if you are trying to be defensively positioned, then not being fully hedged could be something to consider if we do go into recession, as this could be an important source of portfolio return,” he says.
Brendan acknowledges that currencies are notoriously difficult to forecast. Atrium has a Forex-based strategy that examines how the changing role of different factors will impact currency forecasts over time.
“From a portfolio construction perspective, we’re aware of the qualities of having foreign currencies in portfolios and the diversification benefits they can provide. We have a reasonable foreign currency allocation because of its defensive qualities,” he says. “Historically, when you get to around the AUD to USD$0.60 mark — and we’re not too far off that now — that’s when it makes sense to hedge up some foreign currency exposure.”
When it comes to geopolitical concerns, Brendan believes the broader geopolitical landscape has changed significantly, particularly in relation to ‘friendshoring’ and ‘onshoring’, as the West seeks to decouple from China.
“In terms of potential conflict, say between China and Taiwan, we’ve built defensive elements in our portfolio,” says Brendan. “We have some duration, some foreign currency exposures, and we also have reserve currency exposures, which we feel will protect the portfolio. We also run derivative overlays in our strategy for any shock moves in equities and for tail events.
“We believe our approach to portfolio construction provides a robust and resilient framework to protect the portfolio against these types of shocks.”
And what about Donald Trump winning the 2024 U.S. Presidential election? David laughs: “I think Trump is an unhedgeable risk,” he says. “When it comes to geopolitical risks, don’t overcomplicate things. Spread your capital far and wide and avoid putting too much into emerging markets.”
Brendan Paul is Senior Portfolio Manager, Co-head of Multi Asset at Atrium Investment Management;
David Berthon-Jones, CFA is Joint Chief Investment Officer at Aequitas Investment Partners;
and Michael Frearson, CFA is Director, Head of Fixed Income at Real Asset Management Group.
They spoke on ‘Structuring the defensive part of the portfolio’ at the 2023 IMAP Independent Thought Conference in Melbourne.
The session was moderated by Rebecca Jacques — Head of Portfolio Solutions, Wealth at Mercer.