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When and how to go defensive in the market

Hedging strategies help, and they are cheapest when investors are at their most optimistic


Date: November 20, 2015

Given the volatile markets of recent months, investors are likely asking themselves: Is it time to go defensive?

Jeff Kaminker, president and portfolio manager of Toronto-based boutique investment firm Frontwater Capital, cites a quote attributed to billionaire investor Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

That means, he says, “you want to be defensive, per Warren Buffett’s comments, when the market is confident and everybody is happy.”

Mr. Kaminker often relies on options strategies to cover potential market leaps or dives for his firm’s affluent clientele. Part of the appeal of betting against the prevailing wisdom – say, through hedging using puts and options – is that this strategy is cheapest when investors are at their most optimistic or pessimistic.

“Generally we want to start getting defensive after we have seen a recent market runup, somewhere in the 10- to 20-per-cent range,” he explains. “That is when they are most confident, in an up market.”

Adding hedges in the form of puts and options also allows people to stay invested in the market – an important feature of the strategy given that no one can reliably “time” the market for safe entry and exit points.

Mr. Kaminker’s firm also regularly references the current and historical price-to-earnings ratio of major equity indices to determine whether stocks are overpriced or at low points.

“If the S&P 500 has a historical P/E in the 15 range and it is trading at 17, we know it is trading at a 15-per-cent premium to its historical ratio,” he said. “Again, that would indicate that the market is slightly ahead of itself.”

Another key for Mr. Kaminker is the Chicago Board Options Exchange Volatility Index, or VIX, which tries to measure the market’s expectation of future volatility. When markets are calm, the volatility is low and buying defensive hedges is relatively cheap.

“When the fear kicks in and the market is in free fall, the volatility skyrockets. It is too late now to layer on hedges just because it is super-costly.”

Given the summer retreat of equities, now is likely not the time to be adopting a defensive stance, says Peter Guay, a portfolio manager with PWL Wealth Management in Montreal.

If your portfolio was balanced in July and you were “on target,” meaning you had a goal for the proportion of bonds and stocks you should hold, “chances are you are now a bit underweight stocks, because they have come down, and therefore if anything now would be the time to be selling some bonds to buy more stocks.”

His firm relies primarily on exchange traded funds (ETFs) of bonds and equities to populate its clients’ portfolios, meaning that most clients have an incredibly broad exposure to the investment world. That changes the portfolio manager’s outlook on what it entails to be defensive.

“Our portfolios are massively diversified, meaning over 6,000 to 7,000 companies in any underlying portfolio that we hold through ETFs primarily spread across 60 countries or so,” Mr. Guay says.

He does, however, encourage clients to shift the balance of their portfolios after bull runs. “If the equity side of your portfolio has grown beyond 5 per cent more than your target – so let’s say you are aiming for 40 per cent bonds and 60 per cent stocks, and you get up to more than 65 per cent stocks because markets go up – then that would be a time to take some profit.”

He employed that very strategy this spring after a strong run for equities in the United States boosted the value of those investments for most of his clients


“We had been trimming, in March, April, May, taking money off the top in the U.S., to get more defensive,” he says. If markets recover again in the new year, he expects to utilize the same strategy with the expectation that some clients are currently increasing their equity holdings.

Canada’s economic reversal of fortune over the past few years, quickly shifting from being the beneficiary of a commodities supercycle and triple-digit oil prices to seeing prices for many of its exports plunge, has meant that investors should be defensive when it comes to betting on Canada.

“We have sort of been defensive on Canada for a while, given oil’s slowdown and the weakness in China,” said Jeff Rivett, an associate portfolio manager with Creed Wealth Management Group in Vancouver.

Given how down investors are on the Canadian story, geographic and sector diversification should be considered part of a defensive strategy, Mr. Rivett said. “Having U.S. dollar exposure, having international dollar exposure, has really been the only place to find gains this year.”

He sees investors finding security by loading up on “the Warren Buffett cheap stocks” that trade at or below their asset value and dividend-paying stocks that provide a healthy income stream.

Safe havens such as dividend equities, however, can become crowded. “Dividends are not necessarily the best answer to being defensive, because if you get enough people all wanting the same thing you tend to get inflated prices.”

His firm’s focus over the past few years has been to invest in companies that pay a dividend but trade fairly close to their net asset value. Call it a Buffett-dividend hybrid.

As for investors who are unsure whether they should be assuming a defensive or more aggressive strategy, he states that people should take a closer look at their portfolios and be prepared to ask tough questions of their advisers.

“Just buying ETFs is not the one-stop solution for people,” he said.

As well, not all dividend-paying companies are created equal and should be judged on what they do with their free cash flow.

“I would rather buy a company that is paying out 50 per cent of their earnings and reinvesting in the business, growing their dividends over time, than a company that is just taking all of their cash flow and paying it to investors. I don’t think that is very defensive.”

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