Premier Miton multi-asset manager Anthony Rayner has questioned whether many of the funds badged as defensive are living up to their billing.
In a commentary note, Rayner made the case that defensive funds do not always make use of the best diversification plays available.
“Seasoned investors understand the importance of having a defensive element to their portfolio, but what’s the best way to construct that defensive element, or indeed to construct a defensive portfolio?,” he said.
“Starting from first principles, for most multi-asset portfolios, equity beta tends to be the biggest portfolio risk. Therefore, from a risk perspective, one of the most pertinent questions is how, and by how much, to diversify equity beta.”
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Rayner said the success depends on the investment environment, because the environment drives how asset classes behaves individually and in relation to each other.
“It might sound blindingly obvious that the environment drives an asset class’s behaviour, but all too frequently investors do not follow this logic through when it comes to the practice of portfolio construction,” he said.
“As we reach the 10-year anniversary of running the macro thematic defensive multi-asset fund, we have seen time and time again that pragmatism is a good place to start when trying to understand risk. Specifically, looking at what is working now to diversify equity risk, rather than just what has worked in the past and extrapolating that forward.”
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Rayner added that it is important to keep in mind there are extended periods when bonds don’t diversify equity and in fact bonds have generally only diversified equity during periods of disinflation.
He also noted that in more normal periods where inflation is elevated, equities and bonds tend to be strongly correlated to each other. In the majority of the periods where inflation risk is elevated and bonds have been correlated with equities, commodities have proved to be a good diversifier of equities.
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“Recognising that the same asset class has not always been the best diversifier of equity risk over time is particularly important for a defensive portfolio, but also for all multi asset portfolios,” Rayner explained.
“In short, a cursory glance at the ‘defensive’ funds on offer illustrates that many will have a fairly fixed and material exposure to bonds and actually often not be nimble enough to embrace the best diversifier of equities at any given time, whichever asset class that might prove to be.”
