Building a defensive portfolio at a time of high volatility

Daniel Hughes and Robin Willis

Premier Miton Defensive Growth Fund

Managing portfolio risk used to be a simpler task; first set your allocation to equities and then diversify risk through an allocation to bonds. This is what has become commonly known as the 60:40 portfolio. This method has worked brilliantly well as the ‘low risk’ bond diversifier in the portfolio has been in a 30 year bull trend so you’ve made positive returns from both parts of your portfolio. Bonds have also done a decent job in reducing portfolio drawdowns during significant market crashes such as the Global Financial Crisis or the recent COVID-19 crash.

The idea that an allocation to bonds within a portfolio can help reduce your risk relies on making assumptions about correlation, or in other words, how the prices of both asset classes will interact; if bond prices go up when equity prices go down, you reduce risk, simple enough. What happens when bond prices go down at the same time as equity prices, like we saw in the first quarter of the year? Well, you lose in both parts of your portfolio and suddenly that 60:40 portfolio allocation doesn’t look so clever.

Many commentators have wrongly called the end of the bond bull market. Whether August 2020 truly marks the top of the market for government bond valuations or not remains to be seen, but what we can say with certainty is that bonds have done a very poor job in reducing portfolio drawdown so far this year. Persistent, high inflation has forced the hand of central banks and they have started to reverse the era of ultra-loose monetary policy through raising interest rates and signalling the end of quantitative easing. It seems reasonable that as the asset class that has directly benefitted the most from loose monetary policy, bonds stand to suffer as monetary policy is tightened.

As portfolio managers there is clearly a lot to contend with in the current environment; including the risk of further escalation in Ukraine, the Covid lockdowns in China, and growing fears that central banks will be unable to avoid economic slowdown as they continue to grapple with strong inflation. Persistent, elevated volatility we are experiencing in financial markets highlights the importance of a flexible risk management framework.

Our approach to managing risk is very different to the traditional equity/bond allocation in a 60:40 portfolio, we take a bottom-up approach rather than top-down, focussing on building a portfolio of diversified strategies from the investment company and derivatives universes. Both these universes are broad which affords a high degree of flexibility to the fund mandate. We look to deliver a consistent low volatility return profile and positive returns over the medium term, (three year periods) in any market conditions, which means our primary focus has to be on managing risk.

The starting point is to seek out investments that we believe will have a low sensitivity to the broader macro economy, which naturally leads us to alternative asset classes and using derivatives to structure investments with low correlation to traditional asset classes such as equities and bonds. This helps the fund remain defensive when financial markets experience periods of high volatility usually associated with drawdowns.

The fund is built around a core of defensive, bond alternatives that offer the potential of attractive risk-adjusted returns versus the broader fixed income universe. These are investments with bond-like characteristics that tend to have a relatively short maturity profile and low sensitivity to broader market moves. They are investments that have a more predictable return profile over time as they display a pull to par effect, this generates a stable core to the return profile of the fund.

We also have an allocation to alternative investments which are investments outside of the more conventional asset classes of equities and bonds. Traditionally the largest alternative asset classes have been hedge funds, real estate, infrastructure and private equity but in recent years the range of opportunities, and how you can access those, has widened significantly. Examples of new asset classes we have recently gained exposure to include music royalties, energy efficiency projects and digital infrastructure. The performance of alternative investments tends to be less sensitive to broader economic and financial market conditions and therefore can be a useful diversifier for portfolios. In fact some positions, through the use of derivatives, may benefit from market volatility and therefore perform strongly while conventional asset classes are under stress. This has the effect of dampening overall portfolio volatility resulting in a smoother return profile for investors.

Diversification is the primary risk management tool available to many multi asset fund mandates, this relies on historic correlations to balance equity portfolios with allocations to bonds, cash or even gold. When these correlations break down, the theory on which these portfolios are modelled and structured falls down. If your diversifying assets lose value at the same time as your equity portfolio, as has been the case with bonds this year, then the choice you are left with is to reduce the riskier parts of your portfolio and hold more cash. This clearly reduces risk but at what cost to the potential return of the portfolio?

Whilst diversification, through an allocation to alternatives, plays an important role, having the flexibility to use derivatives means risk can be managed in a more targeted way through expressing bearish views on markets. We actively manage a combination of reactive portfolio hedges with investment strategies that are designed to perform in prolonged market drawdowns or tail risk events such as the COVID-19 crash. This means we are not forced to hold assets we don’t want to. Having that flexibility is an important tool at a time of such high uncertainty and volatility in financial markets.

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Risks

The value of investments may fluctuate which will cause the value of a portfolio to fall as well as rise and investors may not get back the original amount invested.

Alternative investments – these typically behave differently to traditional investments such as bonds and equities. They can include a range of assets such as specialist lending, private equity, hedge funds and gold. Adding alternative investments to a portfolio can help to make it more diverse but can also make it more volatile.

Derivatives are contracts whose value is based on the change in price of a specific asset or index. When derivatives are used within a fund, it doesn’t necessarily increase risk. However, price changes in the underlying asset can translate into big swings in the value of derivatives (up and down), which has a direct effect on the value of the fund.

Changes in central bank interest rates can affect all types of assets, in particular, securities such as government bonds and corporate bonds that generally offer a fixed level of interest. If interest rates go up, the value of a bond may fall, and vice versa.

Government and corporate bonds generally offer a fixed level of interest to investors, so their value can be affected by changes in interest rates. When central bank interest rates fall, investors may be prepared to pay more for bonds and bond prices tend to rise. If interest rates rise, bonds may be less valuable to investors and their prices can fall.

Equities (shares) can experience high levels of price fluctuation.

Higher inflation can lead to some investments falling in value, particularly those with a fixed level of interest, for example government bonds and corporate bonds.

A hedge is designed to offset the risk of another investment falling in price. It can also act as a limit on potential gains if the investment that has been hedged increases in value.

Property values can rise and fall sharply depending on the strength of a country’s economy.

Future forecasts are not reliable indicators of future returns.

Zero dividend preference shares are issued by investment trusts. ZDPs have a maturity date, pay no income but pay a set amount at maturity. Serious falls in market levels can alter their structure and lead to falling values.

IMPORTANT INFORMATION:

For Investment Professionals only. No other persons should rely on any information contained in this fund manager insight.

Whilst every effort has been made to ensure the accuracy of the information contained within this document, we regret that we cannot accept responsibility for any omissions or errors. The information given and opinions expressed are subject to change and should not be interpreted as investment advice. Reference to any particular stock or investment does not constitute a recommendation to buy or sell the stock / investment.

All data is sourced to Premier Miton unless otherwise stated. Persons who do not have professional experience in matters relating to investments should not rely on the content of this document.

For your protection, calls may be monitored and recorded for training and quality assurance purposes.

A free, English language copy of the fund’s full prospectus, the Key Investor Information Document and Supplementary Information Document are available on the Premier Miton website, or you can request copies by calling us on 01483 306090.

Financial Promotion issued by Premier Miton Investors. Premier Portfolio Managers Limited is registered in England no. 01235867. Premier Fund Managers Limited is registered in England no. 02274227. Both companies are authorised and regulated by the Financial Conduct Authority and are members of the ‘Premier Miton Investors’ marketing group and subsidiaries of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

006253/080422

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This section of the website and the content it contains is for retail clients only and by persons who are resident in the United Kingdom [who are not US persons]. Professional advisers should refer to the Professional Advisers site.

The content of the pages of this website is for your general information only. It, and the products and services described within it, are subject to change without notice. We shall not be liable to you, or any third party, for any amendment, modification, suspension or discontinuance of any product or service described on our website. Neither we, nor any third parties, provide any warranty or guarantee as to the accuracy, timeliness, performance, completeness or appropriateness of the information and materials made available on this website.

You acknowledge that such information may contain inaccuracies or errors and we expressly exclude liability for any such inaccuracies or errors to the fullest extent permitted by law. Your use of any information or materials is entirely at your own risk, for which we shall not be liable.

The information contained on this website does not constitute an offer or solicitation to sell or purchase shares in the funds or portfolios or to provide you with other products or services. Any application or investment must only be made on the basis of the relevant documentation of the investment, such as, for example, terms and conditions. The information on this website does not constitute any investment, tax, legal or other advice. Persons who do not have professional experience in matters relating to investments should always consult with an independent financial adviser before making an investment decision. Any opinion expressed on individual funds, services or products represent the views of the individual at the time of preparation and should not be interpreted as a personal recommendation to buy or sell or otherwise trade all or any of the investments that may be referred to.

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This section of the website and the content it contains is for professional financial advisers only and should not be relied upon, or circulated to, retail clients. Retail clients should refer to the Private Investor's site.

The content of the pages of this website is for your general information and use only. It, and the products and services described within it, are subject to change without notice. We shall not be liable to you, or any third party, for any amendment, modification, suspension or discontinuance of any product or service described on our website. Neither we, nor any third parties, provide any warranty or guarantee as to the accuracy, timeliness, performance, completeness or appropriateness of the information and materials made available on this website.

You acknowledge that such information may contain inaccuracies or errors and we expressly exclude liability for any such inaccuracies or errors to the fullest extent permitted by law. Your use of any information or materials is entirely at your own risk, for which we shall not be liable.

The information contained on this website does not constitute an offer or solicitation to sell shares in the funds or portfolio or to provide you with other products or services. Any application or investment must only be made on the basis of the relevant documentation of the investment, such as, for example, terms and conditions. The information on this website does not constitute any investment, tax, legal or other advice. Persons who do not have professional experience in matters relating to investments should always consult with an independent financial adviser before making an investment decision. Any opinion expressed on individual funds, services or products, represent the views of the individual at the time of preparation and should not be interpreted as a personal recommendation to buy or sell or otherwise trade all or any of the investments that may be referred to.

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