On the defensive

There are plenty of reasons why, for cyclical stocks, 2010 is unlikely to feature a repeat of 2009's astonishing performance. "Last year investors were rewarded for embracing risk in all asset classes. Depressed prices and very cheap credit were a powerful combination and investors made spectacular gains from March onwards," comments Robert Pemberton, investment director at wealth manager HFM Columbus. "Equity markets have now reached levels where price to earnings (PE) valuations are around long-term averages suggesting that further share price gains need to be driven by earnings growth rather than valuation expansion.

"Equities no longer have the protection of cheap valuations and after such a spectacular rise a correction would be no surprise. Now is the time to be much more circumspect and think about constructing a portfolio which offers some downside protection as well as enabling the investor to still participate in further market upside in the coming year," he adds.

But don't just bet on bonds

Traditionally, the first port of call for constructing a defensive portfolio would be the fixed-income space, with a significant part of the portfolio typically held in government bonds. However, with the government's quantitative easing program depressing gilt yields, and the creditworthiness of developed world governments currently under scrutiny, this could prove to be a grave mistake.

"The financial crisis has in some ways been transferred from the private to the public sector. As a result, government borrowing is now at astronomic levels and with yields currently still very low, I am negative on the outlook for UK gilts," says Mr Pemberton.

Andrew Wilson, head of investments at wealth advisers, Towry Law agrees, but adds that there should still be an element of your portfolio invested in government bonds, albeit lower than usual and perhaps with a tilt towards index-linked bonds as an insurance policy against future inflation. "Also, global government bonds appear somewhat more attractive than UK gilts, and have the additional advantage of currency diversification," he adds.

Depressed gilt yields also spell trouble for what was arguably the asset class of 2009: corporate bond funds. "These are still producing a healthy income return but we expect little in the way of capital growth in 2010. Spreads over government bonds have narrowed considerably, reducing valuation support while corporate bonds have duration risk (they could fall in value if market interest rates rise) - which needs to be watched carefully," says Mr Pemberton.

Despite these concerns, Mr Wilson says some investors may still have an unusually high proportion of their portfolio bond weighting in corporate bonds, as there is a much greater yield on offer here. Furthermore, many investors now have more faith in corporate management than they do in politicians. "Perhaps one feels happier lending to Tesco than the government," he quips, adding that "we currently have 15 per cent of a typical defensive client's bond exposure in corporates, whereas traditionally it would have been almost negligible as the bond exposure in a defensive portfolio is there to be just that - defensive," he adds.

Many advisers are now opting for strategic bond funds as the preferred way to secure fixed-income exposure. These funds tend to operate under more flexible mandates than plain-vanilla corporate bond funds, allowing the fund mangers to invest across the fixed-income universe, including unlimited amounts in high-yield bonds. These funds can also make use of derivatives to control duration and credit risk. Mr Pemberton's preferred funds in this space include the M&G Optimal Income Fund and Henderson Strategic Bond Fund.

Another possible alternative to fixed income are the NS&I Index-linked Savings Certificates for which the current issue has a tax-free interest yield of inflation plus one per cent for both the three- and five-year issues with your capital secure. Your investment will, however, be limited to £15,000 per issue - but given the current paltry savings rates, this is still a better option than a cash position.

And equity exposure?

A key tenet of a defensive portfolio is that any equity exposure is directed more towards income than capital growth - and with dividends heavily reduced in the banking and mining sectors, that means the more defensive areas of the stock market like utilities and pharmaceuticals.

Last year was not a good year for defensive stocks or those managers, like Invesco Perpetual's Neil Woodford, who skewed their portfolio towards more resilient, dividend-paying holdings such as pharmaceuticals, utilities and tobacco. But past performance doesn't guarantee future performance - and with the era of 'printing money' through quantitative easing drawing to a close and the economy still far from full health, many investors believe a portfolio with a defensive bias should benefit going forward.

"Typically such companies are found in equity income funds with Invesco Perpetual Income Fund and Artemis Income Fund being straightforward picks," adds Mr Pemberton.

Geographical diversification will also help spread the risk, and given the likelihood that sterling may be under pressure in 2010, it would be wise to incorporate some overseas exposure into your defensive portfolio. In this regard, and keeping with the same theme of the importance of income as part of total return, Mr Pemberton suggests the Newton Global Higher Income Fund as a sensible choice. He adds: "I am also a great believer in having a 'wise old head' in my portfolios who has a history of common sense investing whatever the market conditions. Axa Framlington UK Select Opportunities managed by Nigel Thomas fits this particular bill."

Funds to be wary of for now are those with a heavy exposure to last year's winners, including the financial and cyclical stocks.

Despite investors' new found love of emerging markets funds - taking into consideration their impressive run in 2009, and the high risk/reward characteristics - these are generally considered an inappropriate investment for a defensive portfolio. The same argument rules out commodity funds.

Uncorrelated strategies

"With neither equities nor bonds looking especially attractive at the moment we would recommend a 20 per cent weighting in 'uncorrelated strategies'," says Mr Wilson. "By this, we mean sophisticated strategies such as long short equity, macro and managed futures, which are now available in tax -neutral Ucits III wrappers, where there is a greater level of regulation and protection, compared to the traditional hedge fund vehicles of old."

One way of tapping into these strategies is via absolute return funds, which have the capability to protect capital while producing a return in excess of cash. Here, Mr Pemberton favours the BlackRock UK Absolute Alpha Fund and, providing some geographic diversification, Gartmore European Absolute Return Fund.

Another asset class which could add value to a defensive portfolio is commercial property. "Property has the benefit of being a real asset, and one which can perform well at times of increased inflation. Retail property funds are an easy way to gain exposure to an asset class that is starting to perform well again. We also suggest an element in global property securities for extra diversification," says Mr Wilson.

Mr Pemberton agrees that a property fund can provide both diversification and income to a defensive portfolio however he tends to favour the more conservatively managed, daily dealt 'bricks and mortar' UK commercial property funds such as the SWIP Property Trust and M&G Property Portfolio Fund.

Finally, what about gold? Typically an investment in gold will also be considered an 'uncorrelated strategy' as it does not tend to move in parallel with other asset classes. Many investors will also favour gold as a 'must-have' asset class for a defensive portfolio, given its status as a hedge against inflation and currency weakness. However, Mr Pemberton is wary of adding the yellow metal into the mix saying that it is "too speculative an investment with no proper valuation metric."

Source: Robert Pemberton, HFM Columbus