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Building a defensive component of your SMSF portfolio

When financial markets are volatile a defensive component of an investment portfolio becomes especially important. This article explores how to build the defensive component of your SMSF.




When financial markets are volatile a defensive component of an investment portfolio becomes especially important.
 
Here, we explore how to build the defensive component of your self-managed super fund (SMSF).

Defensive assets include cash and fixed income investments such as term deposits, bonds and other investments that pay a coupon based on an interest rate. They are typically thought to be less risky than other asset classes such as shares.

David Palermo is a certified financial planner and director of Capital Wealth Group. He says It’s essential for every diversified portfolio to have a defensive component.

“It's important not only for peace of mind, but it's also a really good layer of diversification. It acts as a backstop and helps when markets are volatile. For those in the pension phase, it is a great way to source some income without tapping into growth assets and pulling funds out in a down market,” he says.

Palermo says having an allocation to defensive stocks is especially important when markets are volatile. “The defensive portion of your portfolio should be negatively correlated to equities. So, when equities are underperforming, your defensive component should act in the opposite way,” he says.

Jeff Rogers, ipac CIO, recently published an article on the correlation between shares and bonds, expecting that they will remain negatively correlated in the near future, meaning bonds still represent a good source of diversification. Read more here.

As to the right allocation to defensive assets, this will be different for every investor, depending on whether the fund is in pension or accumulation phase, the risk appetites of the fund members and the fund’s investment strategy.

“For a lot of our clients, particularly those who are in pension mode, we tend to look to apportion a couple of years’ worth of income to cash investments, for security purposes. For the other portion of the defensive allocation, which can be anywhere between 20 per cent and 30 per cent of the portfolio on average, we'll tilt this towards international and local fixed interest investments. Generally, around 10 to 15 per cent of the portfolio is invested in each of these assets,” he explains.

Palermo usually uses fixed interest managed funds to achieve this exposure. “The funds we select will have a combination of different elements such as corporate and government bonds and credit and hybrid fixed interest. What you invest in depends on the market conditions and outlook.”He says one important element to consider is the term of the instrument. “Duration is important, especially when we anticipate interest rates moving in different directions. Fixed interest funds’ values tend to work in the opposite direction to the way interest rates move. When rates go up, it can negatively affect fixed interest funds. So, when you have shorter duration fixed interest investments it helps to mitigate a bit of that risk. Some of the fixed interest funds we hold have shorter durations, which would mean the holding increases in value if interest rates increase.”

While the coupon the instrument pays is generally set up front, when interest rates come down the value of the bond increases because bonds issued under an earlier, higher interest rate will pay higher interest compared to new bonds that are issued based on the lower interest rate. But the reverse is also true. If interest rates go up, the bonds an investor already holds in a portfolio are not going to be worth as much as the bonds issued subsequently, because investors can buy a new bond at a higher coupon rate. The RBA has kept interest rates on hold since August 2016, and while we have seen good news on confidence, jobs and retail sales, the combination of continuing weak inflation, near record low wages growth, uncertainty around household debt and consumer spending, and the strong Australian dollar mean that it is likely to be too early for the RBA to raise interest rates. Dr Shane Oliver, AMP Capital Chief Economist, remains of the view that rates won’t start rising until later this year – he recently shared his expectations for the bond market here.

Most well-diversified SMSFs will include an allocation to defensive assets. The composition of this element, and the proportion of funds that are allocated to it, will depend on the goals of the fund. There are additional options along the risk curve when it comes to fixed interest, with cash at the least risky end and instruments such as hybrids that also have equity characteristics at the other end.

In other words, there is a wide spectrum of fixed interest investments and it pays to understand what these are when building the defensive component of your portfolio.
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