We’ve covered the potential benefits of defensive equity strategies at length in previous papers, and their increasing market presence over the past decade is testament to their demand from asset owners as well. To summarize: they offer potential market-like (or better) returns, with greater downside protection and a narrower range of outcomes across a full market cycle. With actuarial targets (as well as decreasing fixed income yield and longer lifespans) necessitating an increase in equity exposure for some investors, defensive equity strategies offer a way to increase equity exposure without all of the corresponding increase in risk. As plans often consider equities as a primary liquidity source, and must continue to pay benefits through down markets, mitigating the drag of removing capital at market low points can have a substantial impact beyond less-volatile portfolios with the same annual arithmetic return. Adding potential excess return via an active manager represents even more added value.
To demonstrate the cumulative impact this can have on funding status, we look to the first decade of the millennium. 2020’s recent severe but short-lived dip in equities notwithstanding, investors have become comfortable in this historically long bull market. But we aren’t that far removed from the bursting of a stock market bubble led by tech names with wildly inflated valuations (sound familiar?) and a subprime mortgage crisis virtually no one saw coming. Bookended by two massive drawdowns in U.S. and global equities, that decade represented a worst-case scenario for plans relying on equities to meet return targets. From 2000-2009, the annualized returns (in USD) of the MSCI USA and MSCI World Index were -1.29% and 0.23%, respectively.
In the illustration below, we show a typical scenario in which a plan with a $100 million equity allocation must withdraw 4% annually, increasing with inflation. A plan relying exclusively on passive exposure to a cap-weighted index would have had its market value cut by over 50%. A passive allocation to a minimum volatility index would have lost considerably less, preserving an additional $33 and $40 million for U.S. and global portfolios, respectively. And our hypothetical active strategies producing a consistent excess return above that minimum volatility index would have made an even more profound impact on asset levels, actually increasing market values over this period. This kind of compounding during the worst periods markets have to offer can be the difference between solvency and default for plans without a surplus to burn.
The Challenges of Implementing Defensive Equity
If the growing variety of offerings and increasing asset levels are any indication, the strategic benefits of adding defensive equity to your equity allocation lineup are becoming more and more accepted. It makes practical sense: who wouldn’t want to improve the resiliency of an equity exposure tasked with a greater share of the burden of capital appreciation? Many institutional and individual investors appear to have made this work very well within their equity lineups.
For others, however, it can be tactically awkward. The high tracking error typically associated with defensive positioning that can deviate greatly from the market for long periods can be unpalatable for investment professionals, committees, boards, and even 401(k) participants used to processing manager skill through the lens of relative risk-adjusted returns. They may have a difficult time assessing efficacy in long up-market periods, when typically lagging defensive strategies create poor optics and create behavioral stresses, even when the strategies work as intended.
Change Your Benchmark, Ease Your Evaluation
We offer one method for alleviating this concern: substitute or supplement a defensive equity index for the usual cap-weighted benchmark. And given the constraints of minimum volatility indexes, we believe that active management can improve their value proposition – while maintaining their defensive benefits. Learn how in our latest paper, “How a New Benchmark Adds to Defensive Equity Strategy Evaluation.”
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