There is widespread recognition that we face a very real risk of recession, with industry commentators, ourselves included, predicting more than 50 per cent chance of a recession happening in the next two years. These risky periods are typically associated with serious declines in market returns, therefore it is natural that investors turn their attention towards defensive strategies that emphasise drawdown management during these times. However, we would argue that even outside periods of increased recession risk, defence makes good sense for investors and particularly for those with limited investment time horizons. 
Increased severity and frequency of drawdowns
This need for defence is accentuated by the fact we have identified that investors have experienced even worse and more frequent drawdowns - the fall in value of an asset, from its highest to lowest point, before it recovers back to its peak - during the current bull market, than during previous bull rallies.
Misbehaving drawdowns
We think the nature of markets has evolved since the global financial crisis. Our analysis of markets since 1987 (the year of the Black Monday crash) shows that before 2009, outside of the ‘bear markets’ often associated with recessions – when stock markets drop 20 per cent or more from recent highs – investors tended to see drawdowns that were ‘well-behaved’: an equal weighted bond-equity portfolio suffered very few drawdowns of more than 5 per cent, and never as much as 10 per cent.
By contrast, in the current cycle we have so far seen six episodes of more than 5 per cent drawdown including one of more than 10 per cent – an unprecedented frequency and magnitude of drawdown for a bull market over the last 30 years.
The ‘uncertain economic backdrop’ rolls on - what is to blame?
We think there may be multiple drivers of this increased fragility across asset classes. The rate of economic growth has been slower over this cycle than in past cycles, meaning the global economy has teetered closer to the edge of recession (and therefore to the risk of severe drawdowns) than it did before. To deal with this, central bank market intervention has become more significant and creative than it was previously, potentially leading to a ‘feast or famine’ environment for liquidity. The ability of private sector banks to absorb risk has been curtailed by regulation and shareholder demand for their business models to become more dependable.
Additionally, passive ETFs/tracker indices make up a greater proportion of the investor base than historically, potentially leading to more herding into and out of positions and thereby exacerbating market moves.
The impact of these changes is evident in the number of ‘flash crashes’ – instances when asset values changed significantly over a short period of time – witnessed during this bull market. These flash crashes are not confined solely to equity markets and are likely a consequence of liquidity becoming more susceptible to drying up than was previously the case.
The impact for investors
This changing market structure and the resulting increased frequency and severity of drawdowns has a significant impact for investors. This risk is particularly relevant for those investors whose horizons are not aligned to the economic environment, but rather to their own specific needs for returns, as their assets may not be able to recover from a drawdown in time to meet their liabilities.
By its very nature, a drawdown is more difficult to recover from, the greater its intensity. An investor who suffers a 10 per cent drawdown would require an 11 per cent gain to recoup the losses incurred. Whereas a 50 per cent drawdown would require a 100 per cent gain to break even.
One cohort of investors particularly impacted are retirees, or those approaching retirement. These investors are not able to rely on future earnings being able to fund shortfalls caused by investment losses and so have to depend on the assets they have already built up through their working life. With the world population ageing, these investors are living for longer and so need to make their wealth last for longer. For these investors, drawdowns can be disastrous to their investment objectives.
How to mitigate against the devastating impact of drawdowns
We believe that investors should have an element of defensive returns built into their investment portfolio at all times, irrespective of the market backdrop. This can help to shield against significant capital losses during (often unexpected) times of drawdown and avoid the worst of the negative impact of drawdowns by recovering losses more quickly.
For investors, the benefit of investing in a defensive fund during a recessionary period should be clear, as the aim to reduce drawdowns in significantly falling markets makes it easier to regain capital in the future.
However, with market structure changes leading to the increased frequency and magnitude of bull market drawdowns and flash crashes, a defensive strategy has an important role in an investor’s portfolio throughout the cycle, particularly for those investors with nearer-term liabilities and needs.
This is why we believe that defence always makes sense.
Jason Borbora-Sheen is co-portfolio manager of Investec Diversified Income fund. The views expressed above are his own and should not be taken as investment advice.