Defensive Investing: Guard Your Capital in Uncertain Times

investing during a market rally is straightforward but during periods of economic uncertainty things are more complicated if you're intent on preserving your Capital then a tilt towards defensive investing may be appropriate so in this video we're looking at how to do that under various scenarios but also consider which funds May provide you with downside protection if you do enjoy our content then please do subscribe to this Channel and like this video so let's look at defensive investing in a bit more detail let's begin by what we mean by defensive investing the name of the game here is capital preservation and that's in real terms in other words you have to beat inflation and Beat It by a fairly comfortable margin it doesn't mean that we have no return it just means that we're not really shooting for the Stars here that in turn means that we have to be very careful about controlling the risk of our portfolio what we don't want is to have a large draw down in our Capital that's what we're trying to avoid but if we are investing defensively what are the risks that we're protecting against the reason why that matters is that each risk has a different allocation to protect against the downside now at the moment the risk which is on everyone's Minds is inflation and the types of investment which protect against inflation are usually to do with either having explicit links to the rate of inflation you get that in some inflation-linked bonds for example but also real assets and some Commodities whereas if we're protecting against a credit crunch so this is what we saw in 2008 when it was much more difficult to get credit from Banks but also to get credit via the bond market for example because the cost of borrowing simply soared as people were scared that they'd be higher defaults now that has a cooling effect on not just credit markets but also stock markets and other risky assets and then the third risk that we'll consider is recession this is typically what people think about when they think about defensive investing how do I protect my assets against falling GDP growth so what we're going to do is go through each of those risks in turn to see how we could protect our portfolio against them so let's start off with inflation now there are three types of assets which people consider to be useful when protecting against inflation the first one is something like a real asset this would include things like real estate but also some Commodities which are useful and tangible like copper say so let's look at the evidence for Real Estate first of all what I've shown here is Real Estate Investment Trust in the US and I've plotted its return on the y-axis versus inflation on the x-axis so you can see the relationship between the two and this is based on annual returns and annual inflation now you'll notice that in 2022 vanguard's Reit fund actually had big negative returns so it certainly didn't provide protection against inflation that's because at the same time as we had high inflation we had very high interest rates and because real estate investment trusts usually depend in directly on cheap funding that certainly weighed on the return of this fund another real estate funds so personally I don't think this is a good way to hedge against a very high period of inflation another asset class which people think is a good hedge against inflation is gold and certainly if you look at the late 70s you can see these huge returns of the far right of the graph but that was largely due to the end of the Bretton Woods agreement now that was when the dollar effectively lost its Peg to gold and the dollar weakened a lot gold strengthened a lot and that's not going to repeat itself but during periods of normal inflation I think gold has not really proved it itself to be a very good inflation hedge at least in 2022 what we can say is that it didn't fall a lot it kind of held its value only fell a little bit in fact and so yeah it's okay but it's not as good as people think what I do think is a good investment if you do want to have an explicit link between the value of your investment and inflation is something like an inflation-linked Bond now the problem here is that if you look at the returns in 2022 in this graph there was a very large negative return why is that well it's because the real yield that's inflation-adjusted yields Rose a lot and when yields rise real yields inflation-linked bond prices fall just like they would for a normal Bond however if you hold a single inflation linked Bond you never have to sell you can simply hold it to maturity so you wouldn't necessarily take a capital loss unless you bought it at a negative year field certainly personally I've made a video about buying an inflation-linked Bond and the returns I'm making on that are pretty good because its value is linked to the rate of RPI inflation in the UK the one thing to bear in mind is if you're buying inflation-linked bonds you have to know what the break-even rate of inflation is now this is the rate of inflation which is baked into the bond prices for inflation-linked bonds and if inflation exceeds that break-even rate over the life of the bond then you're better off buying an inflation linked Bond compared to a normal Government Bond so for pension craft users we've got a break-even monitor so that you can see what the break-even rates are in the UK and this updates regularly it's actually quite difficult to dig this out to the bank of England's website so this and other trackers are useful for members of pension craft and you also get access to members only videos such as when I bought my inflation linked Buy Bond and you also get access to our chat application so you can ask a question whenever you want if you want to learn more about membership just go to our website pensioncraft.com the second kind of Crisis which people want to defend against is called a credit crunch now the one that everyone remembers is the one in 2008 and 2009 this is when Banks but also credit markets kind of seize up so before that crisis it was easy and relatively cheap to get a loan in the bond market or from a bank after the crisis you either couldn't get a loan or it was really expensive to borrow money and that tends to slow down the economy and it also tends to be a drag on Equity because that kind of depends on credit as the lifeblood of growth and when you choke off that lifeblood then the equity Market tends to wilt so what do you look out for when you're looking at a credit crisis well what you look for his pockets of Leverage these are institutions or parts of the market which have borrowed too much when credit was cheap and which are going to pay the price when the cost of borrowing surges as it is now so if we look at the federal reserve's financial stability report and this is a graph from one in May 2023 you can see where those pockets of Leverage are but not in the banking sector because a lot of the risk has been moved out of the banking sector into the non-banking financial sector you can see a Big Slice of that is real estate lenders and leases so those have been lending into that market rather than Banks and it may be there's a credit crunch to come in that space another asset type that depends on credit availability a collateralized loan obligations and asset-backed securities and again credit has been growing in that sector too leverage loans for example in the US have grown hugely and are now in contraction so if you are investing in any of those sectors or depend on the financing from those sectors then that should be a worry to you particularly is the banking crisis in the U.S is likely to lead to tighter lending conditions and a credit crunch the bank of England's got a nice diagram which you can see here which explains how both companies and households are negatively impacted by a credit crunch really it comes down to reduced investment by companies doing one of these credit crunches and reduced spending by households at the same time that's because if households are spending less then that's lower revenue for companies because their goods and services don't have so much demand and in turn if companies are spending Less on investment that's going to also produce a cooling of the economy that means layoffs that means higher unemployment and that means a kind of downward spiral this is what the bank of England's trying to avoid while at the same time it's trying to cool inflation by reducing demand a little bit but not too much if it gets The Balancing Act wrong then it could tip the UK into recession and that's actually looking likely at the moment I'd say if you look at the amount of debt which UK companies have it certainly peaked during the global financial crisis it fell and now it's been increasing for some time what's particularly worrying is if you look at the amount of debt relative to the earnings of those companies that's been gradually creeping up it peaked during the pandemic it has come down a little bit but not a lot and really that's what matters can companies service their existing debt if they have trouble servicing it then we're going to see more bankruptcies and the bank of England's broken it down by sector and what's really interesting is if you look at the intro rest cover ratios that's what they mean by icr imagine a company's got a hundred million left after it's paid all its bills but its debt servicing costs are also 100 million then it doesn't have a spare penny left and that company could well go bankrupt so an interest coverage ratio of one is a real danger Point what you can see on this graph is the amount of debt by sector where the interest coverage ratio is 2.5 or lower so that's not critical but it's in the risky Zone I'd say and the sectors which are most at risk according to this analysis are the transport sector because energy costs have been very high and that's been a problem because that's an input cost for that sector but also surprisingly information and Communications as a sector so if the interest coverage ratios are low you should be careful about your stock investments in that sector and what this graph also does which is interesting is it compares the amount of distressed debt in each sector compared to where it was in the global financial crisis in 2008 and again the one that really stands out is the information and communication sector that has a huge amount of its interest coverage ratio below that 2.5 level much more so than it did in 2008. so all I'd say here is be careful about the sectors you invest in and check those interest coverage ratios and make sure you understand them and finally let's look at recession now this is something that people have been trying to protect against for a long time and so the kind of asset allocation understanding of it is much greater than it is for inflation which hasn't been a problem for a while so what I've shown here is GDP growth on the x-axis versus the return on the S P 500 the spy tracker in fact on the y-axis or the return on the TLT treasury tracker this is long duration U.S treasuries and what you can see here is a positive relationship between GDP and the spy tracker stocks love GDP growth they hate recessions whereas you see the opposite relationship for TLT bonds love economic grief and low growth and they hate high growth so if you want to protect against a recession typically what people have done is to buy treasuries now of course we've just had one of the biggest sell-offs in treasuries in history but what that means now is that yields are much higher and that probably means that you've got more of a buffer built into treasuries now they offer a higher yield a higher income than you did when yields were close to zero or even negative and certainly as inflation comes down what I expect will happen is that stocks and U.S treasuries will lose their positive correlation so the protection that we saw previously from a 60 40 portfolio will kind of recover so if you do think we're going to enter a period of weak growth then yeah I think treasuries could provide protection as they did before if we stay in the equity space then you've also got the choice between cyclical sectors that are linked to GDP growth and defensive sectors which have a smaller correlation with GDP growth still not negative but less positive and I've shown two extreme sectors here the top one is consumer staples the classic defensive sector why is it defensive well if there's a recession you've still got to eat you've still got to go to Walmart so that would be a very defensive stock and in the bottom panel you can see the returns of one of the most cyclical sectors that's energy versus GDP and there the correlation is much steeper it's a much more positive relationship between the two so this is a much more cyclical sector so if you do think that we're entering a period of weaker growth then you'd go for the defensive sector what I've shown here is the regression coefficient which shows you how strongly related returns are by sector relative to GDP so right at the top there you can see that energy has the strongest cyclicality that's the sector that's historically benefited most from growth and then the least cyclical sectors the most defensive ones would be Consumer Staples that we saw previously but also Healthcare and utilities the coefficients they're a much smaller so they're much less linked to growth but what if you want to delegate the choice of what's defensive to someone else to a fund manager well here you'd buy a defensive fund and I think these fall into two categories one of them would be protective puts now these are derivatives which gain value as the price of stocks Falls and that's written into the derivative itself so these are guaranteed to gain in value as stocks fall and that's their great benefit the drawback with these funds is that you have to pay a very high insurance premium the option premium in order to maintain the Hedge now over the long term that insurance premium eats away at your return so this isn't the type of fund that you could just hold forever and have as a large proportion of your portfolio in order to use it best of all you'd have to have really good Market timing and let's be honest none of us has that in order to buy it just before a crash alternatively you could just have an allocation that you dial up and down according to your worries the other class of funds which I think are probably easier to use are cautious funds these are designed in such a way that they try to spot the tail risks at any point in time and avoid a big fall in the value of your fund at the same time they try to maintain some positive return it won't be as good as pure Equity but it'll be pretty good good hopefully if it's a well-run fund and really the problem with these funds is you've got to have faith in the ability of the manager to do that risk management so not only have they got to have skill but you've got to have faith in their skill and be right about that Faith but if they do pan out to have that skill then you can have a larger allocation to these funds and you don't have to use Market timing to choose them you can just have it as say part of your Global Equity exposure the drawback here is that sometimes the manager won't get it right and secondly usually you'll pay high fees whether they get it right or not the protective put strategy is what you get with tail for ETF officially this is called the Cambria tail risk ETF and this buys puts which surge in value if the stock market Falls sharply so for example if you look at 2020 the Blue Line surges upwards when markets fail the other fund which you can see here is the LF rougher absolute return fund this is the name of the fund which is marketed in the UK there's a US version as well and what this tries to do is to buy downside protection at all times based on what the managers see as the risks at that point in time and for pension craft members I had a great interview with two of the fund managers from rougher where they talked about their strategy it was really entertaining and as a member you get to see that but notice also that for the rougher fund it has done a fairly good job of generating return it's not as good as just buying Global equity and holding it but it is less crashy and particularly during those drawdown periods the sharp drawdowns it did a very good job of preserving its value so to take an example let's look at the very sharp sell-off in the pandemic so this is from February to March 2020. the Cambria tail risk ETF surged upwards in value by about 30 percent at the same time as stock markets fell about the same amount but in a downwards Direction so msci World fell by over 30 percent so did the S P 500 so if you could have foreseen that fall yeah Cambria tail risk ETF would have been great but if you couldn't foresee it then something like rougher would have been interesting that only fell by about four percent during that sharp sell-off now I've also shown some other tail risk ETFs in the US so for example I've got the quadratic interest rate volatility and inflation the Hedge ETF with the ticker eyeball which also did pretty well during that sell-off and also the amplify Black Swan growth and treasury core ETF which is called Swan over the UK I've shown various investment trusts which claim to be Capital protection funds but which didn't do particularly well during this sell-off compared to rougher say and that's even clearer if we push back our analysis to 2007 so the two best performing funds you can see here are iwrd which is an ishares msci World ETF and that's denominated in Sterling but also gspc which is the S P 500 Index but what's really interesting is that the rougher fund isn't too far behind those two that's done pretty well simply by dodging all of the bullets which have happened in between 2007 and now whereas other UK investment trusts haven't done quite such a good job of not crashing during each of these successive crises so certainly historically rough has done the best job amongst these investment trusts so if you are in a fortunate position and that you don't need a huge amount of return in order to achieve your financial goals maybe you've sold your company and you've got enough money you just don't want to screw it up then maybe this would be appropriate for you one of these approaches which we've detailed today but I think if you have got a very long Horizon just putting it into Global equity and leaving it does a fairly good job and ignoring the volatility that's certainly my Approach for my portfolio now don't forget our offer if you want to join our community you can do that just go to our website pensioncraft.com to learn more and you'll get access to all those tools explainers and our chat applications so you can ask a question whenever you want and as always thank you for listening

Channel: PensionCraft

Views: 43,191

Keywords: stock market, investing, investing strategy 2023, recession, inflation, credit crisis, defensive investing, stock market crash, stocks, defensive stocks, defensive funds, ramin, ramin nakisa, pension craft, pensioncraft

Id: enuER-2itDE

Length: 20min 36sec (1236 seconds)

Published: Sat Jun 17 2023