Partner Insight: Amid today's low yield environment, stretched asset class valuations, and rising geopolitical and monetary policy risks, it is important that the method of how and when to shift the focus towards downside protection is consistent, practical and reliable.
John Stopford and Jason Borbora, managers of the Investec Diversified Income Fund, believe portfolio risk should occasionally be dialled down temporarily for two reasons:
Systemic risks
Investors should monitor the market environment for signs of increased risk and when this occurs they should reduce market exposure even if this means sacrificing short term gains. This decision should be based on a combination of quantitative and qualitative analysis.
Event risks
The possible impact of future events should be thought about. If these events (for example geopolitical tensions or referendums) are determined to have a significant likely impact on the portfolio, and their probability is uncertain but material, then exposure to these can be partly hedged out to reduce unrewarded volatility.
"There are a host of tools available to control risk during periods of market weakness," explains Stopford. "Selling equity futures to reduce equity market exposure, buying or selling bond futures to adjust duration, and hedging currency exposure using forward foreign currency contracts are all liquid and scalable methods of controlling risk when the market environment shows signs of deteriorating. But these tools' efficiency is only maximised when applied to a portfolio whose risk exposure is also appreciated."
"This is why the Investec Diversified Income Fund places risk management at the core of its strategy. By building a portfolio from the bottom-up, rather than through blunt blocks of beta, thereby achieving ‘true' diversification of risk and income, the Fund aims to provide a defensive stance in all market scenarios."
The result of implementing this approach since the fund launched in September 2012 has been positive. The Fund has outperformed the MSCI World Index in all but two of its 18 negative return months since 2012. In fact, the Fund produced positive returns in half of the index's negative periods as a result of individual securities in the portfolio frequently outperforming.
Similarly, and by again ensuring a portfolio is not reliant on just one source of returns, the Diversified Income Fund has shown how, even in the very worst instances of market distress, it can withstand bouts of high volatility and minimise losses. Since inception, the Fund been able to outperform both gilts and global equities during every single one of their respective worst days of performance.
"These are very short time periods and so not something the fund would explicitly seek to achieve," explains Borbora. "Nevertheless, it is very difficult to predict when any single day of losses might occur and so this is a decent demonstration of how the fund's natural set-up is defensive."
Alongside, the fund's focus on bottom-up resilience and structural diversification of a portfolio, which is discussed in more detail here this type of tactical risk management helps to limit drawdown.
To learn more, click here for Investec Asset Management's Guide to Defensification and read how investors can defend against drawdowns.
