Defensive investing first needs defining

As with any strategy, there are pros and cons but the most important thing is to understand what it involves.

Ian Rees, head of research at Premier Asset Management, notes: “It’s got no real relation to a client outcome. If you ask a client, ‘What do you want to achieve?’ they don’t generally say, ‘defensive investing’.

“It’s not as clearly defined as, say, reducing volatility and I don’t think defensive investing is actually about preserving capital. To me defensive investing sounds like you want to be exposed to investments without having the same level of drawdown available elsewhere; you want to take on some risk but do it cautiously. So I think the first part is trying to understand what the term is and how it relates to the client.”

This idea of investing ‘cautiously’ is something many may do without realising they are being defensive, but Richard Colwell, co-manager of the Threadneedle UK Equity Income and the UK Equity Alpha Income funds, agrees that much depends on the definition of defensive investing.

He says: “As an industry there has been too much of an obsession with benchmarking and relative risk and, ultimately, it should be about the avoidance of absolute capital destruction. So why would anybody be anything other than relatively defensive in their approach?”

The general aim of a defensive approach is to achieve sustainable returns across a long period without taking undue risk.

But Mr Colwell notes: “At times when you have strong stockmarket rallies, perhaps people forget what risk is taken to achieve those returns and then they get rudely reminded. So you have to keep on the straight and narrow and remember what you’re about.”

Defensive investing can be implemented in a number of ways, such as through asset allocation, taking a quality approach or using different instruments with defensive qualities.

Mr Rees explains: “The basic way is asset allocation – just using your view on the world to invest in a risk-aware way. Of course, the real problem with that is, what if your macro view is wrong?”

An example of this is gold, which has historically been considered a defensive safe-haven asset and yet in recent times has proven anything but that.

Clyde Rossouw, manager of the £36.4m Investec Global Franchise fund, focuses on high-quality companies and therefore the fund has a fairly defensive style.

“There are only a limited number of companies that have what we would consider to be high-quality credentials, which most importantly would allow them to generate superior returns on the money that is invested in them for long periods.

“We try to buy these companies at what we think is the optimum price. Obviously the reason we’ve added the price qualification is because sometimes you can have a situation where the best businesses in the world do trade at incredibly high prices in relation to their profitability, in which case you might end up suffering an inferior rate of return even if the business carries on doing very well for an extended period.”

He explains that the reason why the style and philosophy of the fund is fairly defensive is because typically one of the requirements of a stock is that it must display a relatively low level of financial risk and, more importantly, have low equity market sensitivity.

Mr Rossouw explains it is a long-term strategy, although there are times when the style does less well, such as during buoyant market conditions, when economically sensitive stocks, such as financials and consumer discretionary groups, perform well.

However, he argues that with this approach “when things [markets] are going very well we generate positive returns, but when things are bad and people are losing a lot of money, we lose less money and our drawdowns are far less.”

Mr Rees agrees that using a quality filter for a defensive approach also requires a valuation part to find the best opportunities.

He notes: “Certainly a lot of quality defensive equity areas in the market became quite expensive earlier this year. So just having a quality bias in a pure equity sense without any valuation filter can be a risk.”

Instead, Mr Rees highlights the possibilities of using other instruments, such as convertible bonds and zero-dividend preference shares that have defensive equity characteristics.

As with any strategy, defensive investing has its benefits and downsides but the key is to decide what it is to be defensive and how that objective is met.