It’s been a testing time for investors this year, with economic and political uncertainty driving high levels of volatility in global stock markets.
As recession looms, investors may be looking for ways to protect their portfolios from an impending economic storm.
Investment experts point to ‘defensive investing’ as an option to consider. Here’s a look at what this means, why it’s useful, and examples of the sort of investments that fall into this category.
Investing in the stock market is inherently risky, and doing so puts your capital at risk. You may not get some or even all of your money back.
What is defensive investing?
Laith Khalaf, head of investment analysis at AJ Bell, describes defensive investing as “a strategy that investors often follow when the global economy is struggling by shifting their portfolio into assets that are less vulnerable to an economic slowdown.”
Defensive investing both aims to reduce the risk of incurring losses, as well as the overall volatility of a portfolio.
Volatility measures fluctuations in the value of an asset over time, which can create an issue if investors need to sell assets when prices have dipped, even temporarily.
Defensive investing typically involves holding a diversified portfolio of asset classes such as lower-risk cash and bonds, plus equities, along with assets whose performance is typically less correlated to stock market movements – such as gold.
James Yardley, senior research analyst at FundCalibre, says: “All investing carries risk. But there is a big difference between a portfolio which is invested 100% in cash and 100% in equities.
“By mixing a range of different and uncorrelated assets, investors can build a defensive portfolio while still potentially maintaining much better returns than cash.”
That said, it’s important that investors build their portfolios according to their individual appetite for risk. Investing should be seen as a long-term strategy. But not all investors are willing, or able, to absorb short-term losses and may only ever want to invest in low-risk assets.
How to invest defensively: Individual company shares
Buying shares in just one or a handful of individual companies is a high-risk investment option leaving investors nowhere to hide from potential losses if each one underperforms.
Two ways investors can help offset these risks, however, are by focusing on certain sectors and then screening companies within a particular sector against certain criteria.
Choosing a sector
The economic downturn has prompted a shift in investor appetite away from high-growth companies, particularly those in the technology sector, to business in less cyclical sectors.
The latter includes companies that benefit from all-round demand for their products, including essentials such as food, drink and healthcare products, bolstering their overall prospects during a recession.
AJ Bell’s Laith Khalaf says: “Traditionally, sectors like tobacco, defence and pharmaceuticals are seen as places to ride out an economic storm, though investors should be aware that some share prices in these areas have risen considerably over the last year, largely because stock markets anticipate economic developments and have therefore already priced in a fair amount of pain.
“It’s important that a portfolio doesn’t become too reliant on one company or sector, and that it still maintains some balance.”
FundCalibre’s Mr Yardley also sounds a note of caution: “It’s a common mistake to think that you can buy low-risk equities. All equities are high risk. Some sectors are typically less risky and less exposed to the economic cycle such as healthcare and utilities.
“Generally, you want a mixture of a range of equity sectors even as a defensive investor. You should then manage your risk by varying the overall equity weight in your portfolio.”
One option would be to increase the proportion of other assets such as cash and bonds and reduce the proportion of equities in the portfolio as a whole.
Stock selection
Although defensive sectors may be more resilient in a recession, investors should still be discriminating when choosing which companies to invest in.
Rosemary Banyard, manager of the VT Downing Unique Opportunities Fund, points to the merits of investing in companies with little or no debt: “Never underestimate the ability of debt to destroy the value of shareholders’ equity in a downturn.
“We have all become de-sensitised to the risks of high debt levels because of the extended period of low or zero interest rates since the global financial crisis. Now we have a sea change in the availability and cost of money, so caution is needed.”
Ms Banyard adds that she prefers businesses with a high level of recurring, or repeat, revenues. “They start the year with a pretty good idea of what their revenues will be and can plan costs accordingly.”
Beyond looking at the debt position and predictable revenue in a company’s annual accounts, investors may also want to consider companies with the ability to be price-setters, particularly in times of inflation, due to their dominant market position, such as Apple and Amazon.
Furthermore, larger companies may have the financial firepower to weather a downturn in profits better than smaller ones.
Expert suggestions
AJ Bell’s Laith Khalaf picks out Imperial Brands: “The tobacco company sells an addictive product which makes sales resilient in a downturn, even though that may be ethically unappealing to some.
“Debt has been coming down in recent years and healthy cash flow has supported a rising dividend since a big cut in 2020.”
Imperial Brands has delivered a share price increase of more than 30% over the past year. The company is currently trading on a dividend yield – a proxy for annual return, based on the dividend divided by the current share price – of almost 7%.
Mr Khalaf also highlights pharma giant AstraZeneca: “The company is one of the world’s leading pharmaceutical companies which provides treatments for cancer, diabetes and asthma, health problems which aren’t going to go away in an economic downturn.
“It has invested heavily in its research and, while the shares aren’t exactly cheap, analysts are expecting profits to grow considerably in the next few years.”
The company has also enjoyed a healthy share price increase of almost 40% over the last 12 months, but is currently trading on a lower dividend yield of 2%.
How to invest defensively: Collective Investments (Funds)
Funds provide investors with a ready-made diversified portfolio of assets, including more defensively-oriented options.
These include ‘absolute return’ funds that aim to make positive returns in any market conditions, and ‘total return’ funds that aim to protect against losses in falling markets and deliver growth in rising markets.
These funds have more defensively-positioned portfolios spread across a range of different assets such as equities, commodities, currencies and bonds, including the use of derivatives. This diversification aims to smooth average returns for investors.
Laith Khalaf comments: “When investors pick defensive funds they tend to think about multi-asset funds, which can have exposure to shares, bonds, commodities, property and cash, with an active manager pulling the strings to move between these asset classes.”
FundCalibre’s James Yardley says: “Specialist tech funds, emerging market equities and smaller companies funds are examples of very high risk funds. Equity income funds still carry a lot of risk as they are equities but are generally on the lower end of risk for equity funds.”
However, he adds that the main way to reduce risk is to move away from equities towards other assets such as bonds: “You have much better protection and the risk/reward is looking much better in bonds again. Things would have to be quite extreme for bond funds to lose another 20% next year.”
Fund suggestions
Mr Khalaf picks out Personal Assets Trust and Rathbone Strategic Growth as defensive fund selections, both of which focus on capital preservation (although they may still fall in value): “They won’t shoot the lights out when markets are rising but they will provide protection in a market slump.”
Personal Assets Trust has delivered a total return of 25% over the last five years, and, looking at individual years within this period, has fallen by a maximum of 3%, according to Trustnet data. Rathbone Strategic Growth has achieved a total return of 23% over the last five years, and has fallen by a maximum of 7% in terms of yearly performance.
Mr Yardley picks out VT Gravis UK Infrastructure Income as a defensive option that could help to diversify an investor’s portfolio. The fund has achieved a total return of 31% over the last five years, and, looking at individual years within this period, has fallen by a maximum of 3%, according to Morningstar.
He also highlights LF Ruffer Diversified Return which aims to deliver positive returns in all market conditions. It was launched just over a year ago but has achieved a one-year return of 4% compared to a zero return for the absolute return sector, according to Trustnet.
How do defensive investments perform when the economy recovers?
We also asked our experts whether investors should look to reposition their portfolios less defensively when the economy returns to growth.
Mr Yardley says: “A defensive portfolio should still go up in absolute terms if built properly, but it will obviously lag a 100% equity portfolio.
“Investors should consider rebalancing if the risk/reward for an asset class changes substantially, or if the weights differ meaningfully altering the risk profile.”
Risk factors could include the negative effect of interest rate rises on bond prices and a slowdown in consumer spending on share prices.
Laith Khalaf comments: “Generally speaking, a defensive portfolio will get left behind when markets are in a strong bull phase, as global investors will turn to more economically sensitive sectors like energy and financials.
“It’s impossible to predict which way the global economy is turning and it can lead to over-trading if you keep selling and buying funds and shares every time the economic winds look like they’re changing.
“A better approach is to have a balanced portfolio which invests in both defensive and cyclical stocks, and then make minor adjustments as you go along if there is a compelling reason to do so.”
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