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Last month, the Toronto Raptors won their first NBA Championship in franchise history against the Golden State Warriors, who had one of the most dominant offences of the last five years. It is interesting to analyse how the Raptors pulled it off. Not only did they lead offensively by scoring more points and making more free throws, but they also had unrelenting defence with more steals and rebounds, and fewer turnovers. As the saying goes, defence is the best offence.
The same can be said for an investment portfolio. You make your gains during a bull market, but once the market environment starts to change, what can you do as an investor to seek to protect those gains and get defensive whilst still seeing some returns?
Following are some defensive asset classes that can assist in the quest for lower overall portfolio volatility and smaller drawdowns, or which typically have been uncorrelated to equities in the long term.
Fixed income is a defensive asset class which plays an important role in well-diversified portfolios. Not only do you receive regular income that typically can be expected to exceed the income from a term deposit or cash account, but it can also add diversification benefits to a portfolio to help guard against cyclical downturns. In uncertain times, risk averse investors tend to shift assets from the uncertain cashflows of equities to the safer, known cash flows of investment-grade fixed rate bonds.
The duration component of fixed income (the sensitivity of a bond’s price to changes in interest rates) historically has been where its negative correlation to equities has come from, and we have seen this over the last 12 months in a falling interest rate environment. For a long duration fixed income product, BetaShares offers the Australian Investment Grade Corporate Bond ETF (ASX: CRED).
The recent election was a huge positive for the ASX Hybrids sector. With a Coalition victory, the threat to the cash refundability of surplus franking credits was removed, to the relief of those retirees who rely on cash refunds for income. In addition to providing attractive, tax-effective income, hybrids historically have shown around 1/3 the volatility of the broad equities market. For exposure to an actively managed portfolio of hybrids, check out the BetaShares Active Australian Hybrids Fund (managed fund) (ASX: HBRD).
Gold is defensive in nature due to its historically low correlation and beta versus equity markets. Gold has been trading in a band over the last few years of the current bull market run, although just last month, it broke out of that range to hit a 6-year high in US dollar terms, and its highest-ever price in AUD terms.
If the equities market was to enter a period of decline, gold could once more find favour. Lower interest rates also mean the opportunity cost of holding gold falls, and central banks around the world have been shifting to an easing bias. For pure exposure to gold bullion which is physically backed, take a look at the BetaShares Gold Bullion ETF – Currency Hedged (ASX: QAU).
Companies that rate highly on quality factors have tended to outperform lesser quality peers because they are more financially healthy. During slowdown and contraction phases of the cycle, quality companies have tended to be less volatile and suffer lower drawdowns, as investors have been drawn to them. Such companies, having relatively low leverage and high cash flow, tend to be better placed to survive a recession or credit crunch.
It is always difficult to predict the end of a bull market cycle, and it is not inconceivable that equities will continue to rally for some time, considering the softening in interest rates. Rather than trying to time the market, remaining exposed could be considered – but to higher quality companies that are defensive in nature. For an exposure to global equities that are screened for quality, sneak a peek at the BetaShares Quality Leaders ETF (ASX: QLTY).
Playing defence with your portfolio doesn’t necessarily have to mean performance suffers. It just means that your opportunity for gains will come from different sources and not rely solely on equities. And just like a NBA Championship series can’t be won relying solely on offence, a winning portfolio doesn’t need to be invested in equities 100% of the time. This is what being truly diversified is all about.
A special shout-out to the 2019 NBA Champions and my home town team, the Toronto Raptors!
Note: The above information is general in nature and is not personal financial advice.
Image source: cbc.ca, Frank Gunn/The Canadian Press