At Evergreen, we are lucky enough to work with high quality financial planning firms. I often chair their Investment Committees, so I’m fortunate in hearing their unique perspectives about the investment issues facing both them and their clients, and I get to help them find solutions.
One of the major issues that a lot of planning firms are grappling with is the changing nature of the defensive parts of their clients’ investment portfolios.
Traditionally, and by that, I mean up to about 8 to 10 years ago, defensive portfolios were made up primarily of bonds, a bit of credit and cash. Pre-GFC, mortgages were also often included for a substantial portion of a portfolio. Those assets provided a number of benefits in a multi-asset portfolio context.
Firstly, they provided capital stability. Most experienced advisers will be aware that bonds are not always negatively correlated to equities, but they generally do provide downside protection in a crisis. Mortgage funds usually had a fixed unit price, with income being paid every month. Cash funds were similar. Hence, mark-to-market risk was low in those assets. They provided the ultimate capital stability, low price volatility and seemingly great correlation benefits.
Secondly, they provided good levels of income. In the aftermath of the GFC, term deposits were paying up to 7% pa for five years (that’s not a typo). Even considering the higher levels of inflation we experienced, income was comparatively easy to generate from these low risk assets.
Hence, overall, an adviser could rely upon growth assets to provide long term capital growth, and they could slowly adjust asset allocations to increase defensive assets through an investor’s life, thereby improving capital stability (or risk), and moving nicely from growth to income production.
Fast forward to today. Mortgage funds’ supposed capital stability has been long ago been exposed as a myth. Cash rates are minimal. Bond yields are extraordinarily low, meaning investment professionals everywhere are questioning their future potential for downside protection. Credit can provide good income but, as we have seen in recent months, is not capital stable.
So, both of the fundamental purposes of a traditional defensive portfolio have been undermined by the changing characteristics of traditional defensive assets over the past decade. They now produce low absolute levels of income, except potentially through trading, and they are not as capital stable as they seemed to be.
This is a difficult conundrum for all investors, but particularly for those closer to retirement, who would have traditionally relied on those assets to fund their twilight years.
Over the past decade, the response has been, more and more, to rely on growth assets for both growth and income generation. The unconventional monetary policies that have been pursued by many central banks since the GFC has led to a boom in asset prices, so this has worked well in buoying portfolio values and potentially supplementing income by realising gains. Further, we have seen bond yields steadily fall to record lows, providing gains in that asset class over time. To supplement this, property and some asset classes not previously considered by financial advisers, such as infrastructure, have evolved into being the income-producing parts of a portfolio.
So things have not been too bad. However, we may now be at a crossroads. By many measures, and not to infer any opinion on the future direction of the stock market, equities are expensive. Further, dividends are being cut, so income generation from the asset class is unclear. Certain parts of the property sector – retail and office – look like they are under stress and rents (and therefore income) may fall. How much further can bond yields fall?
I’m not sure there is an easy solution to this problem. However, one thing I have seen advisers think deeply about, and which I think is extremely valid, is the actual role of the defensive part of the portfolio. If it is primarily there to ensure capital stability above all else, and not so much to help with overall income or returns, then a case can be made for very low risk assets, such as cash. If returns are important, then risk needs to be taken, but this does add an element of volatility that may be higher than that experienced in the past.
In the end, how portfolios are structured is a question for advisers to consider in the context of their clients’ needs and objectives, with help from people like me. Nonetheless, it is clearly one that has been made infinitely more difficult over the past decade.