Navigation Search
Close

Select your location and role to view strategy and fund content

Namibia
  • Global homepage
  • Australia
  • Botswana
  • Denmark
  • Deutschland
  • España
  • Finland (Suomi)
  • France
  • Hong Kong (香港)
  • Ireland
  • Italia
  • Luxembourg
  • Namibia
  • Nederland
  • Norway
  • Österreich
  • Singapore
  • South Africa
  • Sweden (Sverige)
  • Switzerland
  • United Kingdom
  • United States
  • International
Professional Investor
  • Professional Investor
  • Individual Investor

Tailored for investment professionals this site provides information on our products, strategies and services. Please remember capital is at risk and past performance is not a guide to the future.

By entering you agree to our Terms & Conditions

Login to My Investec

Download PDF version >
February 2016 | Volume 17
  • The UK and Europe: in or out?
    ___________
    The starting gun has been fired for the UK’s referendum on EU membership.
  • Gold regains its shine
    __________
    Heightened geopolitical tensions and EM currency depreciation sparks gold revival...
  • Credit market developments
    __________
    Credit market weakness has become increasingly pervasive...

My kingdom for a hedge: A letter from Philip Saunders

Yet again most developed government bonds have proved their worth as a defensive hedge in the recent market turmoil. However, with yields at historically low levels and entering negative territory in a number of cases, the protective quality of such exposure in the future is surely becoming more doubtful. Recent market price action arguably suggests that market participants have increasingly abandoned bonds as material defensive positions in portfolios, in favour of ‘procyclical risk management’ which is designed to protect returns and mute any drawdowns in a generally rising market environment. Lately, for example, we have seen a scramble to buy hedges to lower or cap increasing risk, as measured by short-term volatility. Given poor liquidity, there has also been a significant expansion in the use of proxies (designed to mimic the behaviour of traditional hedging instruments) to hedge positions, which in turn increases correlations. This can often result in ‘technical factors’ overwhelming fundamentals and contributing to bearish sentiment.

We have long been advocates of taking a broader view of the ‘defensive’ opportunity set and focusing on the qualities of structural diversification, rather than relying excessively on short-term market timing, particularly if it is reactive, to manage risk. If the laws of diminishing defensiveness increasingly apply to government bonds, what might take their place? This is a difficult question because bonds have typically paid investors a return and were generally reliably inversely correlated with growth assets. Sadly, this golden era is largely in the past. Hedging is becoming more costly and less reliable. The behaviour of more complex defensive assets, when their qualities are needed, is more difficult to predict than more conventional hedges. Volatility-protection strategies are a good example of this, as they can show an alarming tendency to diverge from the underlying asset.

Despite its impressive recent performance, even a more conventional hedge, such as gold, pays no income and can be costly in terms of drawdown.

So what other defensive options are there? We would argue that currencies have long provided a fertile defensive opportunity set. Typically the currencies of credit or nations, such as Switzerland and Japan, have offered safe havens (although the yen lost this status under prime minister Shinzo Abe and governor of the Bank of Japan Haruhiko Kuroda), and periodically the US dollar by dint of its ‘world currency’ status. Naturally, as the depreciation of the Norwegian krone in the recent past reminds us, cyclical context and valuation remain important considerations, even if longer-term structural fundamentals are robust. Taking short positions against currencies with poor or deteriorating macroeconomic fundamentals greatly expands the opportunity set. The Australian dollar was one of the main beneficiaries of China’s boom and as a consequence was driven up to unsustainable levels. Selling that currency forward proved to be an excellent hedge against general emerging market weakness, as it declined by 37.7% from a peak in November 2011 to its recent trough. More generally, the principle of shorting growth assets to create defensive ones applies more broadly than currencies.

In short, we need to consider the broadest range of defensive assets in order to sustain structural diversification in portfolios at a time when the traditional defensive ‘armoury’ is becoming challenged. True, this opportunity set is in some cases difficult to access and requires additional technical skills and competence, but we believe the alternative of placing undue reliance on market timing and the standard risk models is misguided.
 

Philip Saunders
Co-Head of Multi-Asset


"Recent market price action arguably suggests that market participants have increasingly abandoned bonds as material defensive positions"

Related links


Forecasting is a particularly unreliable basis for most investment decisions

Important information

This communication is provided for general information only and should not be viewed as a recommendation or a solicitation of an offer to buy, sell or hold a security, investment or derivative, or as a recommendation to adopt any investment strategy. No representation is made that any of the services, securities or investments referred to herein are suitable for any particular investor. The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct, and Investec’s intentions to buy or sell particular securities in the future may change. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.