Four ways to protect your portfolio in a recession

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Let’s start obviously with the fund and where it’s positioned – it’s in the Investment Association Flexible sector. So, the allocation can be pretty much anything you like with some boundaries, obviously, but given the rough start of the year for investors, how much have you made use of that ability to sort of move around in the portfolio and in terms of the asset allocation?

[00:34] Yes. Thanks Chris. It is definitely a very good question, because as you say, it’s been quite a turbulent start of the year. We started the year expecting recovery in the economy, recovery in markets to continue. Then the invasion of Ukraine happened shifting the focus towards inflation, which then became concerns about recession. You can add some political uncertainty to the mix as well, particularly here in the UK. So, it has been a difficult environment to navigate.

What we did, however, all that being said, the past couple of months, we’ve been a lot more active from an asset allocation standpoint. And it’s not because our view on the macro economy has changed, but there again, it is where we see value emerging. So, we’ve been adding quite substantially to our fixed income exposure in the portfolio – about 3.5% or also – and that’s on the back of the very difficult first half for fixed income markets, the worst performance for bonds, global bonds, in decades, really. And when you saw yields on US or UK 10-year bonds doubling in the space of six months.

So, we think that there is now a lot more attraction in the yields that we are seeing in the fixed income market.

We’ve also been adding to floating rates. So, there in the broad bond universe we particularly like floating rates, which are loans in effect. But where the rates move in line with what the benchmark rates are doing. So, that provides some inflation protection. So, we’ve been adding to that part of the market.

And also from valuation standpoint, we’ve been adding to private equity, within private equity as sort of quite aggressively because in the investment trust sector, the discounts have widened quite a lot because investors replay in their mind what we saw in the great financial crisis of 2008/2009, where a lot of those trusts had portfolios that weren’t performing well. They were very indebted. So, a lot of those trusts headed into trouble, but within this situation is very different. Currently, operationally, the portfolios are performing very well. Debt is well under control. So, there isn’t a lot of leverage and discounts on some of the trusts that we own at 35 to 45% seem unjustified to us. So, we’ve been adding to that area.

And the last thing that we’ve done, just over the past few weeks we’ve built up our dry powder – our cash level – which was around 2.5% to 3% at the start of the year. It’s now 4.5%. And that’s on the back of the strong performance that we’ve seen really since the beginning of the summer in risk assets. So, we’ve seen quite a good recovery.

We think it’s probably a bit too early to call the end of the bear market. And we’re probably going to see more volatility over the next few weeks or months. So, we want to have some dry powder ready to deploy as and when we see opportunities over the next few weeks.

Will you be looking to sort of dip in? Because I mean, obviously inflation’s been a buzzword for a number of months, and we’re now sort of at this sort of tipping point where there’s talk of inflation peaking and maybe the threat of recession is now looming much larger. I mean, how do you sort of get through those sticky periods? And you mentioned the cash holding there – would you look to drip feed that in at some point?

[4:42] Yeah, so we will definitely drip that in, at some point. I think the focus has now shifted. It shifted as you are alluding to. Whether inflation is peaking or not, I don’t know, and I don’t think anyone will know. It’s likely to remain sticky for months to come, but what has probably peaked for the time being are investors’ expectations of inflation. And that for us, as investors ourselves, is what matters. So, it’s figuring out what’s priced into the market. And the shift is now very much on recession as central bankers have made it quite clear.

The way we look at our portfolio entering this very difficult period is that there are several ways you can protect your portfolio in a recessional stagflation environment.

The first one is to have defensive assets. So, we have a number of absolute return strategies in our portfolio – around 8%, 9%. We also own some gold, which we think is a good hedge against inflation and an increase in risk aversion. As I mentioned, we’ve got cash. We’ve got fixed income, which while for years really hasn’t provided any downside protection given how low yields were, within now that has changed with yields being higher. There is a margin of safety now, and we would expect fixed income to provide protection if equities were to sell off. And another defensive area we’ve got exposure to, is in the infrastructure space. So, there it is
defensive, because the income streams are often inflation-linked and are quite predictable. So, it’s quite easy to model. You’ve got some visibility and investors tend to like that in a period of recession. So, defensive assets is one [way].

Then secondly, I would say, focusing on the quality of the assets that we own. So, we always do that. We always look for the quality managers that then go and look [for] the best assets they can find out there, but it is going to be increasingly important in the current environment. Then valuation is going to be increasingly important as well. So, investing in things where you know you’ve got a sufficient margin of safety, and that has proved very valuable in the first six months of this year, when you’ve seen value equities outperforming the growth equities, it’s because you’ve got that margin of safety embedded there.

And if we look at a sector that I mentioned earlier, like floating rates, for example, we think the fundamentals remain quite strong in that sector. And a lot of them are backed by physical assets. So, even in a case of default, the managers can get the capital back, and you are getting north of 10% yield on some of those strategies that we own, which we think from a valuation standpoint is particularly appealing.

And the last point I would say on how to try and protect the portfolio in the recession is something that we do is to look for idiosyncratic strategies. So, it’s very difficult to find strategies that are going to be completely uncorrelated, but we are looking for managers that are trying to be masters of their own destiny really, and try to invest in, create a portfolio that should behave quite differently from the rest of the market. And shouldn’t be too impacted by big macroeconomic dynamics.

So, for example, in the equity space, that would be activist managers that invest in companies and then go and try and convince the board to implement changes that then create value for the share price, or private equity sector that I mentioned already. But there again, the managers are really, they are sitting on the board, they invest for the long term, and we feel that they have more control which means that the performance of their portfolio is going to look quite different from the broader market.

Obviously we sort of covered quite a bit there. So, I just want to touch on a couple of points just before we finish. So, firstly, in terms of investment trusts and alternatives, you sort of explained there how they’ve been useful sources of alternate return. Do you envisage that bucket of the portfolio increasing in the next few months?

[10:19] Yeah. So on the investment trusts. First, we always own between 60% and 80% in investment trusts. And that has been the case since the fund was launched in 2004. So, our focus is really on investment trusts. At the start of the year, we were towards the lower end of that allocation. So, towards the 60%, and that allocation has now increased, and it is a function of well, some stock specific ideas like in the floating rates area we’ve added positions in VPC Specialty Lending for example.

But also, a function of valuations, the discounts generally have widened across sectors in investment trusts since the start of the year, which is what you would expect in a risk-off environment. So, investors run for the exit, sell their holdings, which means that the discounts will widen. So, that means that for us, they’re looking more and more attractive. And an example there is we have switched some of our equity exposure from open-ended funds to investment trust, for example, because for similar strategies, let’s say similar portfolios, we sell an open-ended fund at what is par by definition. And then we can buy the equivalent in the investment trust world at an attractive discount. So, we think that is quite an attractive thing.

So yes, I would expect the investment trust allocation to continue creeping up. So, it’s now around 67%, 68% of our portfolio. Obviously, we need to be aware of liquidity as well. That’s why we’ve got open-ended funds, but if the discounts continue to widen, we will be adding to our exposure.