With many investors believing the valuations of traditional defensive equities are now too expensive to offer a margin of safety, multi-asset managers have been shifting towards cash, REITs, US inflation-linked treasuries and gold to protect their portfolios.
This comes following FE Trustnet’s latest poll which found that 65 per cent of more than 1,000 respondents think defensive equities are now too overvalued to play their traditional protective role.
Given the series of potential geopolitical headwinds we face in the form of the impending US election, the Italian referendum and the triggering of Article 50 next year, investors would be forgiven for moving into more defensive positions at the moment.
However, traditionally ‘safe’ government bonds now offer historically low – or in some cases, negative – yields and are becoming increasingly volatile.
Dividend-paying stalwart stocks or ‘bond proxies’ are also trading on historically high valuations, given that ultra-loose monetary policy and the hunt for income have driven many investors into this part of the market.
Performance of indices in 2016
Source: FE Analytics
Should investors be deterred from investing in traditional defensive stocks and look elsewhere, or is it worth paying high prices in spite of valuation risk? We ask a selection of multi-asset managers how they’re positioned.
Troy’s Tom Yeowart: “The attractions of gold as a safe haven are increasingly apparent”
The manager of the Troy Spectrum fund believes that developed market equity valuations are elevated and companies are struggling to grow given high debt levels and the low-growth environment.
“Rather than constantly tweaking the sails, we navigate these difficult waters by holding a combination of cash, US treasury inflation-protected securities and gold alongside our global equities,” he explained.
“With policymakers seemingly prepared to be ever more adventurous, the attractions of gold as a safe haven are increasingly apparent. Benefiting from a general compression in yields, inflation-linked bonds have performed relatively well in a disinflationary environment. However, they also offer protection if further forays into the monetary and fiscal unknown eventually stimulate inflation.
“Cash helps dampen volatility but, more importantly, provides the flexibility to invest in attractive opportunities as they arise.”
David Coombs: “We remain traditional in our portfolio make-up”
FE Alpha Manager Coombs, who is head of multi-asset at Rathbones, believes equities that offer strong prospects of sustainable growth rather than traditional defensives such as tobacco and utilities stocks should be held at the moment.
“We’re not looking for shoot-the-lights-out, eye-popping expansion, but solid, dependable, mid-single-digit revenue gains. For us, this growth has to be accompanied by low debt and high returns on equity,” he explained.
“We remain traditional in our portfolio make-up, using the rest of our portfolio to defend against volatility. We have added Swiss franc-dominated debt issued by Credit Suisse and Vodafone to our fixed income holdings. These were bought at low yields, but they offer strong diversification because they have very low or negative correlations with equities.
“The Swiss franc is a classic flight-to-quality trade. Alongside this, we have also bought 10-year gilts after yields recently broke through 1 per cent. Our cash levels are near all-time highs and we have been adding to our US treasury inflation-protected securities as well.”
Anthony Rayner: “We have reduced the ‘traditional defensives’ but become more diversified”
The co-manager of the cautious and defensive multi-asset funds at Miton says positioning should vary depending on which market risks the investor is looking to protect themselves against.
When it comes to protecting against inflation, for instance, he said: “We have been defending against [domestic inflationary pressures] through UK stocks that have overseas earnings, we also have very little interest rate risk in bonds, i.e. are not particularly exposed to interest rate moves.”
“In addition, we have exposure to gold as an inflation hedge. More generally, we also have more exposure to the inflation/growth friendly sectors such as energy, materials and infrastructure.”
Performance of indices since start of data
Source: FE Analytics
To defend against weak growth, Rayner says infrastructure exposure could be helpful as it will make fiscal expansion more likely. He has also reduced interest rate risk in his bond exposure and bought credit in case the bond sell-off worsens.
“In general, we have reduced the ‘traditional defensives’ but become more diversified – we have reduced our fairly dominant lower for longer exposure in the portfolio over recent months, which had worked well for the funds for a number of years,” he continued.
“We have also increased our exposure to a broader range of unrelated investments, for example, UK infrastructure, Mexican airports, the Indian consumer, resources (oil and mining) and a basket of Hong Kong stocks that complement our themes such as new energy and demographics.”
Simon Evan-Cook: “We have a decent exposure to well-run value funds”
Evan-Cook, fund manager at Premier Asset Management, says there are still individual defensive stocks that are too few and far between to be picked up by smart beta strategies. As such, he is buying into carefully-selected active managers.
“They are still able to construct a portfolio of attractively valued individual ideas that, collectively, will lessen any permanent damage to capital that a market sell-off might otherwise cause,” he said.
“We’re also looking to stay off the beaten track, as some of the most dangerous areas are those to which the most investors have flocked. This is another good reason to avoid passive vehicles, which are increasingly becoming representative of ‘the flock’.
“So we have a decent exposure to well-run value funds, which have not typically been defensive in the past, but now may turn out to be just that, due to much more appealing valuations that build in a level of downside protection. Again, a degree of selectivity here is key, as avoiding value traps is crucial.”
Evan-Cook is also using a modest basket of market neutral funds to provide defensive exposure within the team’s higher growth funds. In the bond portfolio Premier is holding asset-backed securities as it believes they’re not yet overbought but are beginning to gain more interest from pension funds.
Ben Conway: “The best you can do is have valuations on your side”
Ben Conway, senior fund manager at Hawksmoor, says that having valuations on side and trying to find uncorrelated assets is the best way for investors to position themselves defensively. However, he says this has never been harder.
“Investment trusts, as closed-ended vehicles, enable us to access more illiquid assets than we’d be able to access via open-ended funds alone. At the moment, some of the best value in financial markets is to be found among some of these more illiquid asset classes,” he explained.
“The issue is that investment trusts themselves can be relatively small (£50-250m) and illiquid. This is a problem if you are a multi-asset fund running billions but not so much if you are running smaller portfolios. You cannot make these investment trusts significant positions in extremely large portfolios.”
Areas where the manager identifies value (and therefore lower valuation risk) in terms of trusts include niche property and micro-caps.
When it comes to open-ended funds, he favours funds specialising in areas with a strong structural growth story and investment vehicles focusing on short duration high-yield bonds.
Performance of index over 5yrs
Source: FE Analytics
“Indeed, the common trait all these ideas have is an independent driver to their success and cheap valuation, coupled with the assets being accessed by an appropriate structure – whether that be a closed-ended fund or an open-ended fund run by a manager who will cap the AUM,” Conway added.
Lucy Walker: “An overweight position in alternative assets” 
The head of third party funds at Sarasin & Partners says that the recent back up in bond yields combined with historically high equity valuations means the firm has turned to alternatives.
“Sarasin has an overweight position in alternative assets, where we can find diversified return streams and much-needed sources of income,” she said.
“The universe is very broad and both strategy selection and manager selection are even more important than within traditional asset classes, since there is a greater reliance on alpha rather than beta.
“Examples of strategies we have exposure to include uncorrelated strategies such as beta neutral equities and infrastructure, which has become increasingly in favour in recent years, but where we have been longstanding investors because we like the contracted inflation-linked return streams available.”