Poorly structured “defensive” portfolios may simply swap one set of risk factors for another set and, if this issue is not addressed, then the retirement savings goals of a significant number of investors may be compromised, according to Doug Turek, managing director of financial adviser, Professional Wealth.
The conventional approach to investing in defensive assets is not well developed, he says, and requires more consideration by financial planners.
He says that up to one third of the population is unsuited to investing in high growth, high risk assets. But even investors with a relatively high risk tolerance require some level of defensiveness in a properly diversified portfolio.
“In financial planning one of the key processes is to do a risk-tolerance analysis using a number of sophisticated questionnaire-based tools or other tools,” Turek says.
That analysis results in about one-third of all people who complete it being classified as having relatively low risk tolerance – or, as Turek puts it, being “quite intolerant to equity volatility”.
“About a third of the population are ‘nervous’ investors and need stability in the prices of their assets and, as a consequence, they traditionally have a high mix of defensive bond-like, cash-like investments,” he says.
“It’s very important that you have a good strategy for how those assets are going to work. Unfortunately, a lot of them simply swap equity risk, which they are uncomfortable with, for interest rate risk. They hand over the risk of meeting their financial goals to a bunch of central bankers, who are bigger rate-fixers than all those shady guys who’ve been adjusting the LIBOR rate by 0.1 per cent.
“These guys have moved interest rates from 6 to 1 or 0 per cent, and that has an enormous impact.”
Diversity in defense
The defensive portion of a portfolio needs to be carefully diversified across different kinds of defensive assets, according to Turek, because each has a different set of characteristics and a different set of risks.
“One of the reasons why you need to be careful and one of the reasons you introduce inflation-linked bonds… is to diversify against interest rates, because there have been times in Australian history, and it is the time now in overseas markets, where interest rates are not a good enough reward to fight inflation and so just swapping to traditional nominal bonds or cash can be quite unwise,” he says.
“So, we make a strategic argument that it’s important to have a bit more diversity in your defensive portfolio and, therefore, you need a class of bond we think is a very good and clever one, called inflation-linked bonds, whose return is driven mainly by the consumer-price index.”
Lining up your defenses
A starting defensive allocation, reckons Turek, could be to have about one-third of the defensive part of a portfolio invested in each of fixed-rate, floating-rate and inflation-linked securities.
Floating-rate securities include cash and other deposits, short-duration term deposits, floating-rate notes, bank bills and so-called “cash-plus” funds.
Fixed-rate securities include traditional Australian and international bonds (and bond funds, including exchange-traded funds) issued by governments and by appropriate corporations.
Finally, inflation-linked securities include inflation-linked bonds (and bond funds or ETFs) and potentially annuities issued by life-insurance companies.
Dampening portfolio volatility
Turek says the purpose of each component should be quite distinct, too.
Floating-rate securities should dampen portfolio volatility and allow investors to take vantage of rising rates. Fixed-rate securities provide relatively stable income and the potential for capital gains. And inflation-linked securities protect the portfolio against high inflation and low interest rates.
Financial planners have traditionally used just bonds to make up a defensive portion of a portfolio.
“They might just use simple bond funds, which they really didn’t understand,” he says. “Or, if you were a do-it-yourself investor, you’d use term deposits. Now we see those two competing, and people wonder what’s better.
The effects of inflation
“We did some research about three years ago around the effects of inflation. One of the conclusions was we need to make sure the equity part of our portfolios fight inflation… but we were really quite concerned about conservative investors who simply by behaviour can’t tolerate equity risk and might have two-thirds of their money in cash and bonds. Or just people who are older; we’ve always felt they can’t afford as much risk the closer they are to retirement, hence the lifestyle-investing concept.
“There’s about a third of the population that has to be mostly bond and defensive or cash investors, and there wasn’t a very good framework to describe them. And one of the observations we had was, we actually turned over the defensive portfolio to a cast of characters like Glenn Stevens, Ben Bernanke and the Europeans as well, who have a very different mandate than retirees do.
“Importantly, they get to tell retirees what they get to live off by fixing rates.”
