The case for bottom-up defence in portfolio construction

By John Stopford, manager of Investec Diversified Income Fund

Added 22nd July 2016

Delivering a successful defensive investment return profile requires a bottom-up security selection strategy and solid understanding of how individual holdings perform in different market conditions.

The case for bottom-up defence in portfolio construction

The best offence is a good defence

Against the backdrop of elevated political and economic uncertainty, not least in the aftermath of the EU referendum, we think it best to avoid constructing portfolios based purely on simplistic, top-down asset allocation. Instead we believe in taking a thoughtful and forensic approach to picking individual investments, with a focus on higher-quality securities. By doing this, we believe, the severity of negative market events can be reduced. This requires investors to understand thoroughly the true nature of their exposures by building their portfolio from the ‘bottom-up’.

Building a quality portfolio from the bottom-up

An understanding of the attributes which each of the holdings brings to a portfolio can help managers to achieve their desired investment outcome with greater predictability.

Within equities, for example, the perception that a high dividend yield conveys a significant degree of protection is erroneous. Simply because a company is paying out a high dividend relative to its share price does not mean that there should be confidence in the sustainability of its business model or that its management are focused on maximising the interests of shareholders. It can, instead, mean that the company is in distress or that investors have forced its share price down in anticipation of a cut in the dividend.

Rather than looking at the immediate attractions of a high yield, a more defensive approach requires an understanding of a company’s cash flow, profitability, earnings stability and debt-burden. We define businesses which are likely to be able to maintain or grow their income distributions under most circumstances, whether in the form of bond coupons or equity dividends, as ‘quality’ companies. An assessment of the sustainability of the income they offer gives a clearer insight into their relative valuations.

When considering non-UK asset exposure much of the potential risk, especially for bonds, comes in the form of exchange rate volatility. It is therefore generally a good idea to consider such investments on a currency hedged basis when comparing their relative valuations and to analyse their currency separately. This is especially true for emerging market debt, where the volatility of an emerging economy’s exchange rate will typically far outweigh that of its bond market and so expose investors to risks that extend beyond a country’s ability to services its debts.

Kames Income Hub


Vincent McEntegart, manager of the Kames Diversified Monthly Income Fund, explains how he aims to deliver a stable and sustainable income of 5% p.a.*, paid monthly, by investing in a range of asset classes

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