Time to play market defence? Especially when everyone else is playing offence

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Is it time to play defence – or, for our American friends, defense?

The honest answer is that I don’t know. But yes, I think so, and thus I am justified in asking the question: Should defence and protection be priorities for your investment portfolio right now?

We’re in a wonderful time of year for sports, so a sports analogy we will use: “Defence wins games.”

It is said many ways, by coaches and often by players parroting intentionally benign interview responses. But it’s true. Offence (or offense – ha) may be the sexy part, but it’s the staying power of defence that allows the limited offence to shine at the end of the game, or, in investing, over time. Indeed, it can ensure a portfolio’s ability to stay invested over time – where time in the market is deemed to be the key to long term gains.

“Defensive investment strategy” is probably not a common Google search, but it’s at the core of all expert asset-allocation exercises. Stocks, bonds, funds and other exposures are indeed individually selected for their ability to moderate total portfolio risk, to buffer during market downturns and to limit losses.

None of us have to think back too far to recall those loss-limiting periods, even if we have enjoyed a long bull market.

I do have a concern with typically backward-looking asset allocation methodologies, however, even when they do incorporate forward-looking projections. Experts draw too much from past performance, a practice that is notably flawed when that allocation is set in new regimes – for instance, a sticky inflationary environment .

The past 10 or 20 years may end up looking nothing like the next 10 or 20, thus this flawed approach continues not so much because it is great, but simply because it seems to be the best method we have. Most of us don’t call taxis or buy cameras anymore, so maybe asset allocation is ripe for disruption, too. Until then, at a minimum, we do need the right amount of offence and defence.

So, how do you play portfolio defence?

As noted, you need a mix of offence and defence. Said differently, since investing requires a certain amount of risk taking and an allowance for price volatility, offence can be thought of as growth or “risk-on” investments, while defence is usually less-risky assets that are expected to perform differently than your risk-on assets through market cycles. The right amount of defensive exposure allows for the right amount of risky investments in a portfolio, all striving for a target total return.

The great news is that some of these defensive investments are expected to meet portfolio target returns, with their decreased risk profile.

Likely the most common example of this offence/defence portfolio balance was the basis for the traditional 60/40 portfolio, where the 40 per cent in protective bonds was deemed sufficient and effective to work with the 60 per cent in risky stocks. Entire papers have been written recently on how that relationship has broken down, as stocks and bonds have become more correlated and as bonds have failed to provide a satisfactory buffer, threatening portfolio viability.

This has spawned other papers about the “death of 60/40,” or, maybe more importantly, “the new 60/40” – which I subscribe to.

The concept of the new 60/40 portfolio underscores the need for adaptive strategies in asset allocation. As the correlation between stocks and bonds evolves, and as the traditional protective role of bonds is challenged by low interest rates and other factors, incorporating a broader range of asset classes becomes crucial. Credit, particularly investment-grade corporate bonds, select mortgage exposure or structured credit, can offer diversification benefits and yield enhancement opportunities within this evolved paradigm.

It is largely the behavior of and the absolute level of interest rates that have upended the established 60/40 dynamic. The 60 might have changed somewhat, but the 40 has undergone a wholesale makeover. The 40 is now made up of fewer bonds, specific credit investments, mortgages, real estate (equity), infrastructure (equity), and maybe the right market-neutral hedge fund. These asset classes are providing the consistency and ballast that the so-called “fixed income,” or 40 per cent, of the portfolio has traditionally required.

A notable part of this evolution is the emergence of credit as a distinct asset class, including both public and private investments. The realization that the yield of an investment-grade public corporate bond is in fact the combination of an interest rate and a credit spread, and the emergence of funds that can deliver that credit spread exposure without the more volatile interest rate exposure, has enabled change within the 40. The credit and fixed-income evolution is furthered by decreasing bank balance sheets, which have led to compelling private credit opportunities for investors, including investments in loans to companies and exposure to secured mortgages through funds.

Corporate credit, particularly high-quality, investment-grade credit, can play a pivotal role in a defensive strategy. In periods of market volatility or an economic downturn, investment-grade corporate bonds experience fewer or no defaults compared to their high-yield counterparts. They can offer a relatively stable income stream and act as a buffer in a diversified portfolio.

Incorporating a defensive strategy doesn’t mean avoiding risks altogether but rather understanding and managing them intelligently. This involves assessing the credit risk and the interest rate risk separately as well as the potential for each to produce capital appreciation or depreciation. Quantitative models can aid in this assessment, providing a more granular analysis of risk factors.

It is these types of strategies that allow you to play defence, even if only within a total portfolio context. For those concerned with the market outlook, these strategies can offer effective return with lower risk, which might even become your 60 for a while. Cash or GICs are other alternatives, but other than in limited quantities they equate to giving up or accepting too little return. The reality is that the 60/40 has become blurred, even though I still find it to be a useful framework, where playing defence or taking less risk can be achieved in a variety of ways and is no longer a binary investment decision. In fact, the good news is that the recent and expected returns for many of these defensive alternatives actually meet most portfolio return targets with an expected lower volatility and decreased risk profile.

A theme that muddies both public and private assets, which may sit in the 60 or the 40 part of a portfolio, is current valuations. Among the more obvious valuation concerns are office real estate or equity in infrastructure projects, but we also have reason to question the current value (not valuation) in public stocks and bonds. This is not suggesting that any of those are mismarked, rather that the price that a board lot could sell for today or will sell for soon may not match the current and/or fundamental valuation. Your reason for caution might be driven by an overdone stock market, politics, geopolitics, slowing growth in China, concern about a recession, the unknown value of AI companies, valuations without profits, non-transitory inflation, or other concerns.

Absolute return investing

Another related and compelling theme is absolute-return investing, which can provide some of the required defence. Absolute-return investing is focused on producing a positive return in all markets, and not simply a focus on trying to outperform a benchmark. (Even when funds promote their outperformance it may be a loss when the benchmark return is negative.)

Also, do not limit absolute-return investing to the concept of market neutral; rather, market neutral is but one subset. An absolute return approach by an active asset manager works to limit the downside by design, providing defence while often producing significant return. Consider the merits of proven absolute return funds in your portfolio design.

If you are concerned about public or private valuations then you should be considering how to play defence. Among the options to consider are high quality mortgages with insurance or low loan-to-value metrics, a short-term investment-grade credit fund without exposure to rates, the right blue chip dividend portfolio (while recognizing that it is equity exposure), select real estate exposure, and select exposure to interest rates that may not meet return hurdles but reflects your outlook for rates.

Defence may not seem sexy, but it’s essential. It is often the key to winning the championship, and it is a fundamental part of successful long-term investing. And perhaps it is particularly effective when everyone else is playing offence.

Kevin Foley is a managing director, institutional clients at YTM Capital. YTM Capital is a Canadian asset manager focused on “better fixed-income solutions,” specializing in credit and mortgage funds. Kevin is the former head of credit trading and fixed income syndication at a major Canadian bank. He sits on three Canadian foundation boards and investment committees.

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