Why it’s time to trim equities and get defensive

A recurring theme of my articles since May has been to make portfolios more defensive. That means reducing equities exposure and adding cash, fixed interest and infrastructure.

To recap, I am not suggesting a market correction is imminent or that investors should dump equities exposure. Rather, that share investors should cautiously take some profits as the market becomes dearer and implement strategies to preserve capital.

Every investor is different. Do your homework or talk to an adviser before tilting portfolio asset allocations. Selling stocks has capital gains tax (CGT) implications and affects income investors who live off their portfolio’s dividend yield.

Moreover, adding cash and fixed interest to portfolios is a drag on yield. The average rate on a 12-month bank term deposit is about 2%. Most investment-grade Australian corporate bonds are yielding around that and hybrids are flat out yielding 4%.

The forward yield on the S&P/ASX 200 index is a touch over 4% or close to 6% after franking. So income investors must be prepared to sacrifice a few points of yield – which makes a big difference to income – to make portfolios defensive.

It is a conundrum that too many retail investors avoid, in my experience. Some would rather hold overvalued stocks because they need the yield. Others move further up the risk curve to source higher yield, even though they have a conservative investment profile.

I always come back to the first rule of investing: capital preservation. It is no good getting an extra percentage or two of yield if share markets fall 15 to 20% and you are forced to sell. Better to reduce exposure when markets are high and use some of the capital gain for income.

The trouble is, too many investors refuse to reduce the size of their nest egg, fearful they will run out of money. Or they think share markets will quickly recover losses, or their interest in yield vastly overshadows their focus on capital gains or losses.

Clearly, my preference is trimming equities exposure at this point in the cycle. The Australian share market looks overvalued, not wildly so but enough for investors to take some profits. We are in the final stages of one of the longest global bull markets in history.

The bond market is screaming that global recession is imminent. The global equities market is saying the opposite. Governments worldwide keep “kicking the can down the road” with extra monetary policy stimulus and fiscal spending, but it can’t go on forever and could end badly.

Asset class exposures

In terms of asset allocation, I have nominated three key ideas for The Switzer Report in the past eight months. The first, in November 2018, was to add gold exposure to portfolios, a timely idea, given the gold price’s rally this year.

The second idea, in June 2019, was to add cash to portfolios, by blending term deposits (to get a higher rate) or through cash ETFs. The third idea, presented earlier this month, was adding diversified, global core infrastructure exposure to portfolios, principally as a defensive strategy.

I accept infrastructure and other “bond-proxy” stocks will underperform if interest rates rise. Larger infrastructure companies typically have higher debt and high rates reduce the present value of their future cash flow. But I see rates lower in the short term and infrastructure fund managers are factoring in higher rates in their valuations. Investors will be glad they hold infrastructure assets if share markets fall (infrastructure has a lower correlation with equities).

This column adds the fourth part to this defensive strategy: adding fixed-interest exposure. I wish I had done so sooner. The race for yield has driven bond prices higher and boosted total returns. Who would have thought a government-bond managed fund, such as the Mercer Australian Sovereign Bond Fund, would return 10% over one year?

A balanced portfolio (within five years to retirement) might have up to 30% of assets in fixed interest and high-yield income assets. A conservative portfolio (in retirement) could have 50%, although that varies by investor needs, age and risk tolerance.

It is well known that do-it-yourself investors in Australia have nothing like that fixed-interest allocation. Unlike the US, we do not have a culture of small investors owning corporate or government bonds, partly because of complications in buying them over the counter and a lack of awareness and education about the features, benefits and risks of fixed interest.

Fixed-interest ETFs

The emergence of fixed-interest ETFs on ASX is an important innovation for retail investors. Like all ETFs, the fixed-interest variety are quoted on ASX, bought and sold like a share, and have lower fees than active funds. They aim to replicate the price and yield return of an underlying fixed-interest index and suit conservative long-term investors.

Fund inflows in fixed-interest ETFs have been strong this year, a consequence of the race for yield in an environment of low interest rates. By my count, ASX has 22 fixed-interest and cash ETFs. Five years ago there were only a handful of fixed-interest ETFs on ASX.

Most fixed-interest ETFs have returned 7 to 10% over 12 months and a few have done a little better. The Russell Investments Australian Government Bond ETF, for example, has a 12.01% total return to June 2019, ASX investment products data shows.

That is double the Australian share market yield (after franking) with vastly lower risk, given the underlying securities are government bonds. But don’t expect high returns to continue in the next 12 months; rising demand for bonds has driven prices higher and yields lower.

Here are 5 fixed-interest ETFs to consider:

1. Vanguard Australian Fixed Interest ETF (VAF)

VAF is ASX’s largest fixed-interest income ETF just over $1 billion in funds under management. The ETF invests in high-quality, income-generating securities issued by federal and state governments, as well as investment-grade corporate issuers. The five-year annualised return is 4.9% and the management fee is only 20 basis points.

2. iShares Core Composite Bond ETF (IAF)

IAF provides exposure to investment-grade fixed-income bonds issued by federal and state governments, superannuation entities and corporates. It has similar performance over five years to VAF, and fees. It is a good choice for core fixed-income exposure via an ETF.

3. BetaShares Active Australian Hybrids Fund (HBRD)

I first covered HBRD for this report in September 2018. The ETF has returned almost 8% over one year (after fees) to June 2019 through investing in mostly bank hybrids. Managed by Coolabah Capital Investments, HBRD is the market’s first active ETF in hybrids, an ASX-listed security that combines elements of debt and equity instruments and has potential for higher returns and risk.

HBRD comes from a good manager and most retail investors are better of using a diversified fund for hybrid exposure – and relying on a specialist manager – than doing it themselves, given hybrid complexities and risks.

Hybrid returns are compressing, but yield-seeking investors who are prepared to take higher risk could consider this market via an ETF.

4. VanEck Vectors Australian Corporate Bond Plus ETF (PLUS)

PLUS invests in a diversified portfolio of higher-yielding corporate bonds issued in Australia and tracks the performance of the Markit iBoxx AUD Corporates Yield Plus Index.

I like that at least 80% of PLUS must be in investment-grade corporate bonds that have lower risk compared to “junk” bonds. PLUS’s running yield was 3.69% at June 2019.

5. Vanguard International Fixed Interest Index (Hedged) ETF (VIF)

ASX’s largest international fixed-interest ETF provides exposure to high-quality, income-generating securities issued by governments worldwide. VIF is an easy way to include foreign governments in a portfolio and is hedged against currency fluctuations. VIF’s five-year annualised returned was about 5% to June 2019.