Creating a client portfolio that was balanced by containing a variety of assets, with the aim of mitigating against a range of problems was once considered straightforward.
The typical approach was to create a portfolio with 60 per cent in equities and 40 per cent in bonds, with the idea that in calm economic times the equities perform well, and in tougher times the allocation to defensive assets, such as government bonds, would perform better.
Amalia Nunez, an investment director at First State noted that an adviser who adopted the above approach over the past forty years would have delivered good outcomes, and made profits from both the bond and equity parts of the portfolio.
The theory behind this is that when investors are uncertain, they sell off the riskier assets, such as equities and high yield bonds, and switch to assets where the income stream is more predictable, such as a government bond.
When investors are more confident, they shun government bonds, and search for higher returns among riskier assets, because if economic conditions are more benign, those riskier assets can perform as intended.
What does defensive mean?
Mike Coop, fund manager at Morningstar says: “When people say defensive, I take that to mean assets that won’t lose you money."
He says the most important risk is 'fundamental risk'.
This is the risk that: "what you are invested in doesn’t generate the cash you thought it would.
"We call this fundamental risk, and UK and US government bonds will definitely pay you the money you expect, there is no risk that they won’t be able to pay you, or won’t want to pay you, no matter how bad things are, so there is no fundamental risk, and that's valuable during uncertain economic times.”
A major challenge to the orthodoxy of the 60/40 portfolio came in the decade after the global financial crisis.
Policymakers around the world responded to that crisis by introducing a policy called quantitative easing, which involved the central bank buying government bonds, driving the prices up.
The aim was to get government bonds to rise in price, making them relatively less attractive to private sector buyers, and so encourage those to invest in riskier assets that have the capacity to spur economic growth.
Bonds and equities positively correlated
The result of that policy was that bonds and equities both rose at the same time; this is positive for investors but also challenges the central premise of the 60/40 strategy, which is that bonds and equities move in opposite directions.
Nick Watson, a multi-asset investor at Janus Henderson, says the problem for an investor deciding to move away from the 60/40 portfolio over much of the past decade has been that with central bank policy making both asset classes rise in value at the same time, the orthodox approach worked very well, even if it no longer had the protection against market falls.