Leverage: Not just about adding risk
Another way to achieve greater magnitude is to use leverage. Historically, leverage has typically been dialled up to enhance return or yield characteristics, adding degrees of risk to a portfolio overall. But, in future, more investors may consider using leverage to boost the potential defensiveness of traditional asset classes such as Treasuries during an equity and credit sell-off. This type of strategy is not new, though more leverage may be required than before to achieve the desired result, increasing the potential risks if yields spike. Nonetheless, it may allow investors who are comfortable with Treasuries to hold onto them, while increasing the potential for a defensive response.
Pair trades: Asymmetry of risk/returns
Investors can also use techniques such as pair trades. These aim to capture relative value and can provide attractive risk/return characteristics. One example might be going long a less risky government bond, while going short a more vulnerable government bond, perhaps in an emerging market. However, this only makes sense where the risk/reward ratio is asymmetric - heavily skewed in favour of the potential upside, but simultaneously limiting the downside.
Currency: Depends on the base
Currency hedging can be a quick and easy way to manage exposures in a risk-off environment. Being long the US dollar worked well during the crisis, given the dash for dollars early on. But for investors who believe it may now be over-stretched, it could make sense to go long areas such as the yen and the Swiss franc, depending on a portfolio’s base currency. Currency markets can move swiftly, however, and are often first to react to major events; so this is a risk that has to be actively managed.
Commodities and alternatives: Look for non-conformers
Gold may have a role to play in steadying the ship; it has recovered well since it was hit by the dollar liquidity squeeze in March. It could prove equally useful as a store of value if there is stagflation. Where investors can access alternatives, it is worth finding those that don’t conform to risk asset patterns directly or in combination with other assets, but also being selective as each may have different defensive properties. Being long volatility and out-of-the-money put options (the right to sell a stock or bond at a given price) would have helped during the sell-off, but it is important to consider the cost/benefit ratio of these types of hedges - they can be expensive.
Building relative defensiveness through the use of risk assets
Not all defensiveness is about protecting capital in absolute terms; sometimes it can be relative. Long-term investors often prefer to maintain risk exposures during temporary periods of stress, so defensiveness for them may be less about absolute drawdown prevention, and more about defensiveness across their portfolio and through time.
This may include an allocation to defensive equities such as those with lower beta or good cashflows, which typically fall less than cyclical stocks when markets plunge. In the latest crash, there was a clear bias towards quality, and companies with higher ESG scores outperformed those with lower ones. Riskier assets may also outperform one another on a relative basis. So while neither equities nor high yield bonds are classed as defensive, combined in a particular fashion, they can offer defensive characteristics.
From 14 February to 23 March, during which the sharpest sell-off took place, high yield bonds fell 63 per cent of the drop in equities. During the shorter sell-off on 11 June, high yield captured just 25 per cent of the downside. While this is a very short time period for comparison, it demonstrates that liquidity is good for both equities and credit on the way up, but a lot more beneficial for credit on the way down, as this time the Fed is buying corporate bonds and providing a backstop.
So securities with asymmetrical risk profiles can also reduce risk, even if long/short positions are taken in asset classes that are not themselves low-risk or defensive. For example, an investor could go long a defensive equity sector, and short a cyclical one. ‘Defensiveness’ doesn’t always come from exposure to nominally defensive asset classes, and pair trades can offer defensive opportunities across the risk spectrum.
Diversification is as important within a defensive allocation as it is across the whole portfolio. No asset is absolutely defensive all of the time, and investors may need to hold more than just the couple of traditional defensive assets they would have had in the past, to achieve the type of negative correlation they need.
In the current era of low rates, investment grade is unlikely to offer the magnitude of protection it has previously and parts of it may be exposed to defaults in sectors worst hit by the pandemic. So while higher quality corporate bonds can offer some defensive risk in a portfolio, they are unlikely to merit the same weighting as before.
Instead Chinese government bonds, safe haven currencies, select alternatives, defensive equities and long volatility plays all have a role in increasing the defensive nature of portfolios over the medium term. Much will depend on individual requirements, and whether investors are seeking absolute defensiveness (e.g. via an absolute return product) or defensiveness relative to other asset classes, benchmarks or long-term investment parameters.
As the economic data hardens over the coming months, and perhaps some emergency stimulus is rolled back, markets may lose some of their enthusiasm for risk. At the same time, some economies are re-opening and managing the threat of further outbreaks much more effectively than others. Having an all-weather portfolio can help navigate this unprecedented time. That may mean holding some traditional assets, but also thinking laterally about which other assets are truly behaving defensively, to what degree and when.
 Source: https://fidelityinstitutional.com/en/outrunning-a-crisis-sustainability-and-market-outperformance-2ce135/