Four defensive areas for your ISA

The UK officially entered recession on Thursday, 15 February 2024*. Although forecasters don’t expect it to cause “major changes” to consumers’ day-to-day lives and spending, it does add another question mark for investors. There’s more than enough uncertainty in the world for more cautious investors to consider adding some “defensive” holdings to their portfolio. 

What constitutes a defensive holding? Traditionally, defensive stocks and sectors have been those that are ‘non-cyclical’–in other words, they are not dependent on the health of the economy to do well. Examples would be utility companies or consumer staples. 

However, as David Coombs, manager of Rathbone Strategic Growth Portfolio, points out, “to be defensive means different things at different times and the definition of risk can change materially. Investors need to be pragmatic and truly active.”

As every downturn is different, relying on certain sectors to provide defensive characteristics may not provide the protection you need. What broad themes could defensive investors turn to instead? Here we take a look at four areas that may add defensive characteristics to your portfolio. 

Multi-Asset Funds

One option could be multi-asset funds which gives you some protection, but also the potential for some returns. These funds combine a range of different assets and this broad mix of different investments can help to reduce risk. They will have exposure to traditional asset classes such as bonds and equities, but also areas such as renewable energy, music royalties, care homes, logistics or warehouses to add diversification.

A benefit to a multi-asset fund is the manager does all the hard work for you, changing and adapting to market conditions to manage long-term risk. “Heading into 2022 the biggest risk to a multi-asset portfolio was interest rate risk,” according to David Coombs. 

“The landscape has now changed with bond yields much higher. Portfolios are now more likely to see protection from bonds in the event of a recession, so we’ve increased exposure to duration. However, bond markets moved swiftly at the end of last year to price in rate cuts for earlier in 2024 than we believed was reasonable, so we needed to mitigate some of our rate sensitivity. We therefore bought some protection against rising yields via a structure that allows us to make money if yields move higher.”

James Mee, manager of the Waverton Multi-Asset Income fund, tells us more about the role of cash in a portfolio today on the Investing on the go podcast. 

Absolute Return Funds

Another option is the targeted absolute return sector, where you can find a mix of different types of funds. These funds tend to be benchmarked to cash and aim to deliver a consistent return in all market conditions. There are many different flavours of absolute return fund, but we like the Janus Henderson Absolute Return fund, a long/short equity fund with a UK bias. There are limits on the overall market exposure, which serves to reduce the volatility and risk of the fund.

Another option is the BlackRock European Absolute Alpha fund, one of the few targeted absolute return funds which has consistently delivered, returning 33%** and 51%*** for investors over the past 5 and 10 years respectfully. Co-managers Stefan Gries and Stephanie Bothwell employ a fully flexible investment approach with this fund, in order to try and create positive returns regardless of market conditions, with a key focus on capital preservation and low levels of volatility.

Dr Niall O’Connor, manager of the Brooks MacDonald Defensive Capital fund, focuses on investing in undervalued, under-researched and unloved assets. Niall says, “it avoids investing in plain vanilla equities and bonds, and instead has an ‘alternative multi-asset’ mandate.” These assets can include convertible bonds and investment trusts in specialist lending, such as shipping, aircraft, renewables, uranium.

“Re-allocation into the safety of government bonds and growth equities has led many of our holdings to be at record levels of undervaluation,” Niall added. “We see now as a good time to start to rotate into the relative safety of these less stretched asset classes.”

Low Correlation Funds

An attractive option can also be to back equity managers investing in areas that have a low correlation to the wider equity market. These uncorrelated assets should behave differently to one another because their values aren’t influenced by the same factors.

The Polar Capital Global Insurance fund is one such example. The fund invests primarily in the global non-life insurance industry. As manager Nick Martin explains, “a key attraction of the sector is that the driver of net asset value growth for the best companies is their underwriting profits. This profit stream tends to be largely disconnected with the broader economy and financial markets.”

“Also, insurance is mostly a compulsory purchase, often required by law, therefore the industry exhibits robust demand characteristics and has historically been defensive in challenging economic times. As risk continues to rise, we believe so will the demand for insurance.” The fund has returned 266% for investors over the last 10 years*** with outperformance generally coming in more difficult periods, according to Nick.

Digital infrastructure is seen by many as a non-discretionary service, as it hosts our growing digital economy, providing internet access and enabling new applications such as Artificial Intelligence. This provides continued opportunity for Ben Forster, manager of the Schroder Digital Infrastructure fund.

Ben says: “The customers of digital infrastructure – typically defined as data centres, mobile phone towers and fibre optic cable – are stable counterparties who sign long term contracts, with fixed or inflation linked pricing growth. Revenue can continue to grow during economic downturns, as businesses prioritise essential infrastructure spending over variable costs such as marketing. Also, during periods of economic distress, interest rates often fall, benefitting digital infrastructure companies who can access lower cost funding to develop new facilities.”

The low correlation to wider equity markets for both insurance and digital infrastructure are just two examples of how uncorrelated assets can offer diversification benefits and add defensive characteristics to a wider portfolio.

Read more: A guide to uncorrelated asset allocation 

Strategic Bond Funds

Lastly, the flexibility of strategic bond funds means that strategic bond managers can adapt to different market conditions. The Invesco Tactical Bond fund, for example, invests across the whole fixed-income opportunity set. This fund has delivered and performed in different environments and as the ability to adapt quickly to changes in market conditions. It provides investors with a truly differentiated approach to most strategic bond funds. The fund has returned 31%*** over 10 years.

Read more: Is 2024 (still) the year of the bond?

*Source: Sky News, 15 February 2024

**Source: FE Analytics, total returns in sterling, 15 February 2019 to 15 February 2024

***Source: FE Analytics,  total returns in sterling, 15 February 2014 to 15 February 2024