Defensive investments and The Magic Pudding. There are four critical elements to any successful investment strategy these being having the potential to achieve your financial objectives for example having sufficient assets to fund the retirement lifestyle that you want, legally structuring your investments for tax efficiency and to maximize Centrelink for example age pension entitlements, receiving value for money for advice and having robust investment strategies and investments.

For a discussion of the financial objective of having sufficient assets for the retirement lifestyle that you want see my blog Retirement Income – Recurring Golden Eggs at For a no holds barred look at value for money and in particular investment fees have a read of The Multiplici Tonsus at

Today we will chew the fat on what makes for robust investments which are defined as investments that have reasonable potential to achieve returns sufficient to justify the risk. In particular we will have a look at defensive investments. If you want to read about shares as robust investments go to the blogs Share Investing The Value Black Sabbath Approach and Is Cash Trash? both at

As part of an investment strategy it is common to have a portfolio strategy whereby it is intended that a certain percentage of the portfolio will be in defensive investments (interest bearing or other investments that have a low risk of negative capital returns) and growth investments (Australian and international shares and property). For example the asset allocation strategy for a portfolio may be defensive assets 50% and growth assets 50%.

Notwithstanding the disadvantages including no protection from inflation over time and maybe having to restrict access to funds for a few years there are a number of reasons why having some defensive assets in a portfolio makes sense for many investors. Defensive investments result in there being some certainty and stability in a portfolio. Having a defined allocation to defensive assets results in a portfolio that is consistent with your attitude to risk i.e. limits are placed on the proportion of your portfolio that has the potential for negative capital returns. This in turn means that you can broadly be comfortable with your portfolio and get on with worrying about more important things in life like family or travel or dining or who is going to have a deep and meaningful conversation with who in Home and Away or whatever rather than hanging out each morning to see what happened on the Dow overnight. As an aside all of the actors in Home and Away surely deserve congratulations for being able to keep straight faces while delivering those dialogues. Having some defensive assets also means that if you need to draw some capital from your portfolio you have a choice as to whether you take this from growth assets (if the market is high) or defensive assets (if the market is low).

Now the classic examples of defensive investments are cash and term deposits (which in most cases enjoy the benefit of a government guarantee of capital). There are no serious questions here about the security of capital invested. The big problem at the moment as most investors would be acutely aware is the miserable returns available. And the returns are more miserable than yesterday when the Reserve Bank dropped rates again to a record low of 2%. Current cash and term deposit interest rates present a real dilemma for many investors. Do you stick with the reasons why you have money in these types of investments in the first place and accept the returns or do you start actively seeking avenues for higher returns from other alternatives knowing (well hopefully knowing anyway) that it will result in you having a portfolio that has a higher risk exposure than would otherwise be the case.

Shares are one of the major alternatives and investors increasing their exposure to shares in order to get higher income returns is one of the major themes currently pushing the market higher. And this is notwithstanding that we are in what is probably now a mature bull market and that many of the popular “yield” stocks are potentially significantly overvalued and may well result in tears further down the track.

However there are other alternatives that are becoming popular. Generally these are managed investment funds that promise a return higher than that available from term deposits while ostensibly maintaining the character of the investment as a defensive investment. In this category we find enhanced yield funds, income funds, hi-yield funds, capital guaranteed or protected funds, defensive investment funds etc. And in the current interest rate environment there is a seductive appeal about them. What isn’t there to like about an investment that promises security or stability of capital while returning more than term deposits?

While there isn’t necessarily anything wrong with these types of investments they are not magic puddings. These funds still at the end of the day only have shares, property, bonds etc. in which to invest. If a so called defensive fund is producing a return higher than cash, term deposits and bonds the question must be how defensive in reality is the investment? To have confidence that the investment is robust one needs to look through to the underlying assets of the fund to see where your money is actually being invested and understand how the fund manager actually makes the underlying investments and understand how the returns are being achieved. For example do they use borrowed money to beef up the underlying returns? Are there growth assets or derivatives of growth assets in the underlying portfolio? Strategies like this do increase the returns but they also increase the risk. And if the investment environment changes things can go wrong with a capital W.

A number of these types of funds that claimed to have an absolute basis for higher returns ended up only giving grief to their investors when the global financial crisis hit. One classic example (out of a strong field of contenders) that I saw was a fund called Fortress which was run by a major Australian investment institution (name withheld to protect the guilty of course). The fund invested in various interest bearing investments. So far so good. However the fund was leveraged 7 times. In other words for every one dollar from investors the fund borrowed another six dollars. If the investment return is higher than the interest cost that certainly increases, enhances or, insert your own term here, the return over and above what would have been the return if there were no borrowing. An elderly very conservative client of mine ended up with a Fortress fund. She had a cash management trust with the same institution and the Fortress fund had been directly marketed to her. When the GFC hit and the proverbial hit the fan i.e. major capital losses she rang to tell me what she had and what could she do about it. To see what her options were I attended the fund’s teleconference and listened to the rascals (oops fund managers I meant to say) making excuses about once in a lifetime events. Now while the GFC may well have been a once in a lifetime event if you gear up an investment portfolio 7 times you only need about a 15% fall in the value of the underlying assets to wipe out your capital. Assets that fall in value by 15% are not once in a lifetime events they occur regularly. So while this fund produced higher returns while the music continued to play it was also an accident waiting to happen.

These types of funds are also often complex and not always easy to understand. Simplicity is a virtue in many things and is most certainly so when it comes to investments. If an investment is complicated you need to really understand how it works (and what may happen in different market environments) and it doesn’t always hurt to wonder why it is complicated. In some cases the complexity may be necessary to generate higher returns and be justified but in many cases it may be to disguise the real risks or high fee structures. For this reason I usually avoid complicated investment arrangements.

Investments that promise capital protection while yielding higher returns than cash and term deposits have a prima facie increasing appeal in today’s interest rate environment. However remember that if a so called defensive investment is producing a return 2 % to 3% higher than the traditional alternatives it is highly likely that it is doing something unusual to get that additional return and it pays to be cautious and/or questioning. Extra returns don’t come from nowhere. We have not yet had the reincarnation of Norman Lindsay’s Magic Pudding.