This is the secret to a diversified portfolio

It's been a rocky road for equities over the past 12 months with volatility reaching all-time highs. Meanwhile, fixed income investors haven't exactly been on easy street either, with interest rates cut so fine. 

So what if I told you there was a way you could minimise the volatility one traditionally gets in equities, but make a similar return, yet only having the risk level of a government bond?

I know what you're thinking: "Tell me more, tell me more! "

Well friends, look no further than hybrid securities. These curious debt instruments are often underappreciated by the markets but can act as a real portfolio diversifier.

In part one of this collection, I offered you a Hitchhiker's Guide to Hybrids, explaining the ins and outs of this complex asset class. Now I bring to you part two which will explain why hybrids are so important for a portfolio, and how to incorporate them. 

For this question, I had to bring in the big dogs so I reached out to three of Australia's top fixed-income specialists with a particular interest in hybrids. Responses came from: 

• Campbell Dawson, Elstree Investment Management
• Andrew Papageorgiou, Realm Investment House
• Mihkel Kase, Schroders Australia

I then also reached out to BetaShares who recently launched their Australia Major Bank Hybrids Index ETF (ASX:BHYB). They discuss why hybrids wrapped up in an ETF may be the way to get exposure to this exciting instrument. 

Two key reasons you should fit hybrids into your portfolio

Campbell Dawson, Elstree Investment Management

Hybrid securities are important for a few reasons;

1. They have an attractive return/risk profile and provide correlation benefits to both income and growth portfolios.
2. There are a number of assets that provide return and risk profiles between riskless cash and risky equities, but very few are liquid at all times. Hybrids offer good liquidity. Other income types, such as loan funds or LICs, can offer similar or slightly higher income levels, but there is no liquidity in the underlying assets, and this may cause problems for investors who wish to adjust their portfolio from time to time.

Well-structured portfolios should have a variety of risks to ensure smoother performance. Unlike many other income assets, hybrids don’t have much credit risk. The overwhelming proportion of issuers have investment-grade credit ratings and can cope better when there is an economic downturn. However, hybrids do have different risks as described in the previous paragraph, and that offers the benefit of diversification.

Our modelling shows that a 10% allocation to hybrids in a typical diverse portfolio containing the traditional asset classes of bonds, equities, credit and property will reduce the overall portfolio’s risk by as much as 10% without impacting the return outcome.

Be tactical with your exposure

Andrew Papageorgiou, Realm Investment House

The high yield delivered by these assets and the quality of the counterparties that issue them means that the sector shouldn’t be ignored as part of a diversified fixed income portfolio.

We prefer to have a targeted strategic allocation to hybrids, ranging between 0% to 25% of the overall portfolio. The reason we favour a tactical approach to managing our exposure to the asset class is that hybrids have a tendency to extrapolate the present tense. For example, in good markets, investors become complacent and consequently they underestimate the prospect of a negative event, which can see the assets pay returns that under-compensate the holder for the volatility, complexity and relative illiquidity of the securities. 

Equally, in weak markets, the pricing on these assets can infer unrealistically high probabilities of the negative event materialising. In such circumstances, the level of return provided by these assets can be extremely attractive.

When holding hybrids within a portfolio, investors also need to account for the liquidity of this market.

At approximately $43 billion, the Australian hybrid market can be characterised as small. 

In addition, a good portion of the liquidity provided to the market comes from retail channels. While institutional interest has grown over the last half-decade, these investors do not tend to operate within secondary markets on the ASX, meaning that in extreme periods of weakness, investors need to be aware that the markets can trade thinly. Indeed, it is customary for these securities to trade in sums of less than $1million AUD for a day.

What this means is that if you need liquidity on the worst days, you need to be prepared to take a heavy discount to raise the cash you may need.

The tactical use of hybrids as part of a diversified credit portfolio provides a range of benefits, that said, using a hybrid portfolio as a proxy for a diversified fixed income allocation is fraught with danger given the pro-cyclical nature of the assets both in terms of price performance and liquidity.

Return far outweighs the risk

Mihkel Kase, Schroders Australia

For people looking for income, hybrids are giving you access to additional risk premia. By going down the capital structure, being subordinated, you get paid for the additional risk around capital loss. 

In the current environment, where income is hard to come by, an additional risk premium can be attractive if you are happy to take extra risk. 

So for example in bank hybrids, as a credit investor that I'm happy to go down the capital structure and be second in line to senior bonds. If there is not a point of non-viability triggered, then you are earning additional risk premiums of day 150 basis points on average. So you are generating an additional return for taking some incremental risk.

In other words, hybrids allow access to additional risk premia in a way that's inaccessible to many investors.

Why an ETF may be the solution to the confusion 

BetaShares 

The BetaShares Australian Major Bank Hybrids Index ETF (ASX:BHYB) invests in a diversified portfolio of preference shares (a type of hybrid) issued by the four largest or the ‘Big 4’ Australian banks. It aims to provide diversified exposure to some of the most liquid, high-quality hybrids available on the ASX. 

This part of the hybrid market offers less opportunity for an active manager to add alpha or use their skills to manage ‘over the counter’ illiquidity risk – so lends itself to a passive approach.

Thanks to the advent of exchange-traded products, the good news for investors is that it has never been easier to invest in a diversified portfolio of hybrids on the ASX.

Hybrids tend to be relatively complex securities to understand and value. They also trade in a relatively less liquid market, which can place retail investors at somewhat of a disadvantage to experienced professional fund managers when it comes to buying and selling.

Investing in a hybrid security fund, as opposed to individual hybrids, has several benefits, including:

• Portfolio diversification – Investing in a hybrid security fund offers diversified exposure to a spread of hybrids, rather than having to research and choose a couple of individual hybrids only.
• Issuer diversification – Investing in a hybrid security fund means diversified exposure to a range of issuers.
• Liquidity – May benefit from access to superior liquidity compared to directly held hybrids.
• Convenience – Hybrids are quite complex securities with varying terms and conditions. Investing in a hybrid security fund may be more suitable for investors who lack the expertise or time to evaluate whether an individual hybrid suits their investment objectives.

BetaShares offers two hybrid securities funds, BHYB and the BetaShares Active Australian Hybrids Fund (managed fund) (ASX:HBRD). 

Your ticket to finance's only "free lunch" - diversification 

Hybrids may just be the secret to diversifying your portfolio and by removing the risk of equities, and achieving better returns than traditional fixed income, this could be your new secret weapon. 

So now you know what a hybrid is, and you know that you may want to incorporate them into your portfolio ... but where is all the opportunity? Is it just the big four banks that are offering attractive opportunities or do corporate hybrids like Crown, Nufarm and Ramsay Health Care have something to offer, too?

In part three of this Collection, our experts will weigh in on where they are seeing opportunities in the hybrid market currently. Make sure you FOLLOW my profile to be updated when Part 3 is published. 

In case you missed it, part 1 of this collection detailed what a hybrid is and why they're an important asset class. Read it here.