No-one in their right mind would invest purely in a single asset class. Most people are invested in what is called a “balanced” portfolio that contains 60-70% of their assets in equities.
“Balanced” is one of those words that create a feeling of comfort and lack of danger. It’s a bit like the way “gaming” has replaced “gambling” or “climate change” took the place of “global warming”. The effect is the same no matter what you call it. The perception, however, is completely different.
So people invested in “balanced” funds should be able to assume that all their risks are equally weighted, in the way that a seesaw is balanced when two children are on either side. When one child goes up, the other child goes down and vice versa. That’s balance.
The truth is that in a “balanced” portfolio equities are much, much heavier than the other side of the portfolio. The game is fun while equities are obeying the rules, which is to not make any sudden moves. But as soon as equities do anything unexpected, the other side goes crashing to the ground and it all ends in tears.
This is extremely concerning to us when we some Industry Super Funds Balanced and Growth portfolios with 90-100% in Growth Assets. At Kofkin Bond & Co, Balanced means 40-60% growth assets at max.
We also see many financial planners and investors reduce the amount of equity in their portfolios and instead invest in such things as bank hybrids, high yield debt, and listed property. After all, they have a much higher yield than cash or term deposits. Unfortunately, they also have a lot of equities characteristics, particularly during market corrections when they are needed the most. So these clients who think they are diversifying risk are still exposed to potentially large capital losses.
Here are some examples from recent history. Before the Global Financial Crisis, Australian equities and listed property had a three-year correlation of around 30%. Not so much. You could even say it was defensive. But during and since the crisis the correlation has been as high as 80% and is currently around 60%. The higher the positive correlation the higher the likelihood that they will both rise and fall at the same time.
High yield debt (which used to be called junk bonds until Michael Milken went to jail and the name was changed) has had a correlation against equities as low as 10% but is generally in the 40% range. In moments of crisis, however, the correlation shoots up to around 80%! This is not a diversified risk-free asset class.
So what is genuinely defensive? There’s a lot of talk at the moment from Industry Super Funds about products with returns that are uncorrelated with equities returns, such as liquid alternatives, Venture Capital, Private Equity and hedge funds. I’ve got nothing against these products but keep in mind that they tend to be dependent on manager skill. Are they defensive? Not at all in fact in some cases the exact opposite. They are just uncorrelated. They have volatility and will have good years and bad years.
Defensive has to mean it has to provide some sort of defense when things turn bad or to be more specific when equities sustain major losses. The trouble with some assets is that they appear defensive during the good times and then reveal their hidden equities characteristics during the bad.
There is one asset class that is genuinely defensive, it just happens to be the asset class currently with the lowest yield and one which is notoriously difficult to make money from if you’re an active fund manager or Industry Super Fund (so you can’t charge normal active fees), so most managers either specialize in credit (which is low duration) or benchmark their active approaches against cash (which is not comparative at all).
The asset class is government bonds. If you look back at the past 20 years of returns you will see that the average three-year correlation between Australian equities and the Bloomberg Ausbond Composite Index (which is dominated by government bonds) was -23%, with a high of 36% in 2015 and a low of -75% in 2013.
And just to show that is it defensive, Australian equities hade their lowest three-year return at the end of February 2009 with a return of -7%pa. The return from bonds over the same period was positive 9.5%pa. That’s defensive.