Understanding ‘Defensification’ and what it means for investment planning

15 November 2017

The excellent term ‘densification’ comes from a current campaign from Investec AM in relation to their Diversified Income fund. I like it a lot because it combines the broader defensive qualities that many investors are seeking in their investment choices and includes the role of asset allocation and other strategies in achieving this. It also points to the fact that this is a rising concern appropriate to where we are in ‘relationship to the economic cycle’. It’s worth a look.

A company’s approach to asset allocation is becoming increasingly important, given that it provides the foundation to any Central Investment Proposition (indeed any recommendation). There are a couple of interesting dynamics at work here: everyone buys the principle of diversification, and most agree on the prudence of not attempting to time the market. (In fact Aegon has just published some fascinating research showing how fixed or strategic asset allocation investments have been outperforming those with tactical tilts).

However no one knows are the consequences of the creation and now unravelling of trillions of pounds of ‘assets’ on central banks’ balance sheets. Nor the implications of the shift of economic power to the East, or the high valuations in our stock markets.

Our view is that some ratings agencies look to downplay risk, for example by ascribing ratings that remain constant, and in the process, encouraging advisers not to examine or understand the underlying investments in detail. There is a real systemic risk if a disproportionate
number of fund managers have designed their products in line with a single risk model, and the industry conspires at every level to promote this single approach, including groups of advisers who align their risk assessment and investment recommendations accordingly. This monocultural phenomenon means that everybody is sailing ‘in the same boat’ and ironically the protection offered by diversification does not apply to the diversification model itself. There is one boat to survive the storm – rather than many.

As well as the big themes driving the defensive concerns alluded to above, advisers are dealing with clients who are living longer, and are more likely to be transferring out of pensions. Advisers need to quantify possible loss in a full range of circumstances to provide meaningful discussion around Capacity for Loss. Two dimensional solutions that match numbers from profilers and rated investments are not likely to provide the depth of research required, particularly if the approach tends towards a committee view rather than a full range of mathematical possibilities. Just as it is increasingly difficult to imagine effective retirement advice without some kind of cash flow modelling, we feel it is increasingly difficult to advise without some probability based forecasts, in research that is specific to the client.

The Moody’s model provides risk graded fund ratings using risk metrics which are relevant to the distinct savings objectives of different groups of customers:

  • In accumulation, the relevant metrics are the expected returns over 10 years and the potential 1 year losses during the journey (see ‘min gain’ in illustration below).
  • In retirement the relevant metrics are: the maximum sustainable income level; the risk of running out of money and the potential reduction in sustainable income.

Graph: The Moody’s Analytics probabilistic assessment of the original ‘defensification’ fund – Investec Asset Management’s Diversified Income fund. Projection is £100k over 10 year term. Graph from Synaptic Modeller. The blue line represents the strategic asset allocation for the balanced risk category and the green line represents the fund’s risk profile.