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Most defensive equity indexes are promoted as passive-like portfolios designed to give exposure to less volatile stocks, encouraging the development of ETFs and other vehicles designed to track the performance of these indexes at relatively low cost. In order for these portfolios to be commercially viable as investable indexes, however, providers have included unsurprising compromises. This includes constraints on portfolio construction, for example, limits on individual stock, sector or country allocations, as well as turnover and rebalancing frequency.

These concessions should represent an opportunity for a skilled active manager to do better – across several dimensions. For the purposes of comparing the hypothetical strategies that follow, we’ll be focusing on the MSCI World Minimum Volatility index due to its longer track record, as well as its historically greater volatility reduction and Sharpe Ratios over the same time periods, which raise the bar.

Fewer Constraints for More Volatility Reduction

At first glance, it may seem counterintuitive – but reducing the limitations on portfolio positioning can actually allow for reduced risk in a portfolio. The key is in the covariance matrix. By opening up the opportunity set to all stocks in the universe through an optimization process, which considers correlations among all the index stocks in its construction, it’s possible to achieve greater risk reduction than a portfolio comprised solely of low volatility stocks. The result is greater potential for reduced overall portfolio volatility (see figure 1), and reduced drawdown when you need it most. 

At the same time, some constraints are valuable for reducing overreliance on unreliable risk estimates or exposure to overcrowded stocks. Striking the right balance generally requires the skill of an active portfolio manager. Such challenges are not present in vanilla cap-weighted indices, where the largest weights are in exactly the stocks with the greater liquidity, and no active change of target weights is necessary (excepting corporate actions and index reconstitutions).



Variable Beta Targeting for Higher Sharpe Ratios

Defensive equity indexes incorporate the aforementioned constraints for practical and optical reasons associated with indexing, but another drawback is their claimed objective of minimizing portfolio volatility at all times. This is supposed to ensure they’re always working (within their limits) for the lowest standard deviation of returns, including during periods of market turmoil, but this means they don’t intentionally adapt to risk regimes or capture the upside of stable, rising markets.

Introducing a variable beta target into the optimization based on the current level of total market risk provides the best of both worlds: downside protection when markets are turbulent, and participation in the growth potential of calmer, rising market tides. Sounds too good to be true? You may be surprised how simple leading indicators of significant market drawdown and the resulting positioning shifts can be for this to work (see Intech’s Is Volatility a Friend or a Foe?). A more sophisticated implementation only improves the results (see figure 2).



Higher Portfolio Efficiency for Added Alpha

Defensive equity indexes often benefit from the historical outperformance of lower-risk stocks, and are expected to outperform in downturns or periods of market turmoil. But this is an incidental and episodic source of outperformance; in the absence of significant crises, or when the market level of risk is low, this outperformance may not be counted upon to cover implementation costs. Even during market crises, the turnover required for reliably navigating the market can result in overcrowded or concentrated trades that cost both return and risk reduction. Happily, much like a traditional active manager can attempt to improve performance within a tracking error range against a cap-weighted index, so too can you improve performance within a tracking error range against a defensive equity index.

Despite the defensive equity indexes’ significant dispersion during extreme markets of either kind, the indexes’ risk controls still inherently limit their positioning away from the cap-weighted index to a degree. Even moderately relaxing these constraints allows for an active approach to create a significantly more efficient portfolio. More timely risk estimates, more diversified positioning via alpha-aware optimization, and more frequent repositioning and rebalancing offer an opportunity to maintain a similar level of absolute risk while a reliable, and low-volatility independent, alpha source produces consistent excess returns relative to a defensive equity index (see figure 3).



Additional Avenues of Improvement

Markets are constantly changing and finding optimal target weights for stocks in a defensive equity portfolio will depend on a robust alpha source that finds the balance between risk and return. A successful defensive equity strategy should identify a change in the market volatility structure as early and reliably as possible, and trade the portfolios to new target weights as inexpensively as possible.

More Frequent Rebalancing and Updates of Risk Estimates

Even if they forgo the aforementioned alpha opportunity, re-optimization and rebalancing are necessary for any correlation-based portfolio to maintain its positioning relative to its defensive objective, and FTSE & MSCI’s defensive equity indexes are no exception. From this perspective, their semi-annual rebalancing frequency is suboptimal because they fail to adjust to changing conditions in a market that can shift far more quickly.

Less Predictable Trading Patterns

As money flows in to underlying instruments (e.g., ETFs) that follow the index, their impact at each rebalancing date becomes more substantial, and algorithmic traders can profit from this predictability of trading patterns to the detriment of the index itself. Active managers, operating outside of pre-scheduled reconstitutions and the transparency of a published index, offer greater ability to control information leakage and discourage front-running.

Addressing Overcrowding Risk

Since volatility and correlations between stocks tend to change over time, a regime in which correlations between commonly held low volatility stocks are high can severely hamper the ability of such strategies to provide downside protection and, simultaneously, maintain the upside potential.

Measure Their Success

Active defensive equity strategies can be tailored to investor objectives and offer clear potential for improvement over indexes, but what’s the best way to evaluate if they’re delivering on their promise? Are defensive equity indexes useful as benchmarks, or are more sophisticated approaches required? Learn more by downloading our paper entitled, “Making Sense of Defensive Equity Indexes.”

Intech has managed defensive equity strategies since 2012, and we offer a number of investment solutions similar to the hypothetical strategies covered here across a variety of regions.


Making Sense of Defensive Equity Indexes  A closer examination of the major defensive equity indexes. Download Paper


1 It is important to note that the MSCI Minimum Volatility Index has been reengineered (directly, or through adjustment of the underlying Barra Equity Model) a number of times over its history, including after the Global Financial Crisis. Its greater volatility reduction is, at least to some degree, the result of hindsight.
The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Hypothetical performance results presented are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.