Jason Borbora and John Stopford discuss the bull market cycle and defensive returns.
Jason: So, John, this is an unusual object to bring along with you to the office. Why have you brought your cricket helmet to the office and what does it say about 2019?
John: Well, I think our concern, going into next year, is that we are potentially going to face quite a lot of bounces from the market. It is probably not an environment to try and hit sixes. It is going to be much more about, you know, the odd single decent defence and the grill I think is to try and make sure that we get through relatively unscathed. I think 2019 looks like a pretty challenging environment and being protective, being defensive, I think makes a lot of sense.
QE to QT – What does that mean for income assets?
Jason: Okay. So for the last 9 or so years, we have heard a lot about quantitative easing, about central banks helping investors and acting as a tailwind through their policies. That appears to be changing a bit this year and going into next. What do you think the impact is broadly for assets and then specifically for income-generating assets?
John: Well, QE I think has helped push all asset prices higher and the concern that we have is that an unwinding of quantitative easing and, in particular, quantitative tightening may cause everything to sell off together. So investors historically have used government bonds as a diversifying asset. Will they be diversifying in this context? A lot of money has flooded into areas like corporate debt, high yield. Is that now vulnerable to an unwind, particularly lots of people trying to exit at the same time? So I think you have to be much more circumspect. You have to look for alternative ways of diversifying risk and we think, importantly, you have to look at individual securities rather than focussing so much on asset classes.
Jason: Yeah, that is definitely something which I suppose over the last 9 years has also coincided with a big move towards ETF investing, passive allocations and top-down decision-making. We are, obviously, different to that in how we approach it. How do you think that can assist us?
John: I think the individual securities that we are choosing, we are choosing explicitly because they have characteristics which we believe are aligned to the outcome, so a culmination of income but, importantly, sustainability of cash flow generation and resilience underpinning that income and then attractive return characteristics in terms of things like valuation, quality, alignment to the cycle and so on.
I think the problem with passive investments is they are essentially a momentum trade. They work well in a rising market but they will also tend to work in the opposite direction. I think in a falling market. We are not focussed on allocating to passive beta so we are not generally in the areas that are very crowded at the moment where a lot of money has flooded in and so we are probably less vulnerable if that money starts to move out.
Late bull cycle: How do we position for this?
Jason: I suppose we see ourselves as being relatively late in the cycle but still the bull market continues potentially to run. In that environment, there could be some good gains but, presumably, there could also be some significant risks. How do we balance those?
John: Well, it is clearly a challenge. You know the danger a lot of investors fall into I think is they bail out of bull markets too early. They call the top and it is very easy then to miss out on what can be a very profitable part of a market cycle. It is very hard I think to time the end of a bull market.
Fortunately, we would argue at the moment that, actually, you can buy insurance but you are too early, very cheaply you can buy call options on equities at close to the cheapest levels that we have seen through any cycle and that allows you to benefit from further equity market gains but you are not then exposed if equity market falls. So we just think it is bizarre at the moment that investors aren’t really buying that upside insurance but they continue just to own long exposure naked at a time when there is clearly lots of things to worry about.
You can worry about geopolitics; you can worry about trade; you can worry about recession risks; you can worry about policy tightening. All of those things, clearly, could cause the end of a bull market so why just run naked exposure? Why not try and participate through something that gives you upside but not downside?
Jason: That is probably a more reliable method of hedging the portfolio than buying government bonds.
John: Yeah, we would think so. I mean the problem with government bonds is, for large parts of the last 30 years, they have actually moved in the same direction as equities and that is a danger. I think when you have got central banks tightening policy and you have got worries about wages beginning to rise, possibly potential for future inflation and so on. The risk is that central banks carry on tightening policy, bond markets carry on selling off and equities sell off and then you don’t get the hedging or the diversification that you are hoping for from owning bond duration.
So as well as picking resilient yielding securities from the bottom up at a security level, when we are looking at the portfolio as a whole, how do we make sure that we are thinking about not just what might go right but also what might go wrong? How do we build resilience into the portfolio structure?
Jason: I think, importantly, it is not about forecasting. That is something which we are not going spend our time doing. Ultimately, it proves to be a sort of waste of time in many cases.
We are thinking more about the range of outcomes there could be and then providing the portfolio with sufficient exposure across different behaviours so that it doesn’t rely just on one particular outcome and that means stress-testing the portfolio against future events and that could be market-based, it could be geopolitically-based, so that we can understand how it is likely to react in a particular outcome.
That doesn’t mean we can say with definite certainty that we know how it will react in any particular circumstance but we can get a better idea of how it might react and then we can manage the portfolio such that it is not too reliant on any one outcome. That was true in 2016, in particular, with the referendum vote. That has been true this year, in particular, with central bank action and making sure that we are not overly-reliant on fixed income or equities.
John: We are looking to deliver a defensive return profile. Why is that necessary? Why is that desirable in the current environment?
Jason: I think a defensive profile is desirable today because the laundry list of things that can go wrong is much longer than it has been for the last 4 or 5 years. The economic cycle is much longer in the tooth. There is clearly concern around the impact of central bank tightening and the impact on portfolios from that. There are also the heightened geopolitical tensions currently, so the trade war between China and the United States and also the negotiations involving the Brexit process. That is why it ultimately makes sense to be defensive here. I would ask why do you think that we are able to provide that sort of return profile?
John: Well, I think we thought quite clearly about how we go about delivering a defensive return. Firstly, unlike a lot of other people, we think we have got a clear anchor underpinning our return. So we are relying primarily on income and less on capital growth and we think, if you are trying to deliver a defensive return profile, income is the one thing you know a reasonable amount about, particularly if you are picking securities with resilient income generation.
That second element, actually focussing on the individual holdings in the portfolio rather than just making big asset allocation decisions, we also think is pretty important. So picking securities with naturally defensive characteristics, so resilient cash flow generation, a reasonable yield, not necessarily a high yield, and then, ideally, with characteristics that can support some capital appreciation, so decent value, etc., that gives us we think a better than even chance of actually delivering the outcomes we are looking for, and then focussing very much on the risk profile of the portfolio, so making sure it is properly diversified, making sure the balance of risks is managed through time and then a clear focus and a clear range of strategies, including options, including active management to downside risk, including stress-testing for event risks, a real focus on trying to avoid drawdowns through time. Clearly, we won’t avoid them all but, hopefully, we can minimise the impact and then still profit from attractive opportunities that are out there.
Drawdowns - What has worked for us?
Jason: I guess one of the things which has worked, particularly when there is a drawdown in the market, has been the outperformance of the particular securities that we have bought relative to the performance of other asset classes but that is not the only thing that has assisted us throughout time in terms of generating returns. The bottom-up selection is one part of it but what are the other things that help us?
John: Well, clearly, having a focus on making sure that we are always well-diversified and not relying just on backward-looking risk models to tell us about the correlation structure or the behaviour of our portfolio but actually trying to think more deeply about what it is around the current economic environment or current market environment that is causing assets to behave in a particular way and how durable that is.
I think everything we are doing, we are focussing on what can go wrong. So, in that instance, we are thinking about how might the correlation structure change and how might that reduce the diversification I have in the portfolio and how can I build in greater resilience?
Adjusting the mix of the portfolio exposures through time so we have a blend of growth, defensive and uncorrelated positions always but sometimes having a bit more exposure to growth, probably next year gradually moving to a more defensive stance, that allows us essentially to be well-positioned for the kind of environment we are in. Then, importantly, focussing on periods that look more dangerous for markets on reducing overall risk in the portfolio, adopting a temporarily more defensive stance to limit drawdowns, that has worked particularly well. So making sure that we don’t participate too much in negative market events but are still able to capture upside when it is available, that has allowed us so far to compound returns in a relatively consistent manner and clearly that is the focus of what we try and do going forward.