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Redirect Me to

This year’s drawdown has invited a number of inbound questions about defensive equity investing from both clients and consultants. We thought we’d take a moment to answer five of the most common questions we’re receiving right now.

What Kind of Performance Can I Really Expect?

One might believe that the expected performance asymmetry of defensive equity strategies would make them the “holy grail” of equity investing, but the magnitude and duration of up and down markets can produce varying outcomes.

Figure 1 illustrates the range and average returns for a hypothetical global low volatility strategy in down markets, moderately rising markets and sharply rising markets. Most of these strategies tend to lag the market in sharp upturns because of the headwind faced due to betas substantially lower than one. Even in drawdowns, their downside protection may be elusive, depending on the basis for and duration of the selloff. These strategies are not short-term tactical solutions. To make the most of their potential, investors should consider them as part of their long-term policy allocation.


Figure 1 Hypothetical Low Volatility Strategy vs MSCI World Index

How Sensitive Are They to Interest Rate Changes?

Many investors suspect that defensive equity stocks are a form of “bond proxies,” sensitive to interest rate movements. They are concerned about defensive equity strategy performance in rising rate environments just as they assumed they may have benefited from the falling rate environment.

Just like equity market moves, however, the magnitude and duration of interest rate changes can produce varying outcomes. Check out Figure 2. It demonstrates the historical performance of a hypothetical global low volatility equity strategy vs. changes in the 10-year Treasury yield from 1992 through 2018. The R-squared in that relationship was 0.0008.


Figure 2 3-Year Excess Return vs Interest Rate Changes

Over the longer-term time horizons, the sensitivity of defensive strategies to interest rate changes tends to decrease, especially for portfolio-optimized approaches that do not exclusively focus on holding defensive stocks.

Will High Valuations Hurt Future Returns?

As popularity for defensive stocks grows, some investors may be concerned about the potential for higher valuations, believing that they are a threat to future stock returns. But it’s not clear that this relationship holds, especially at the portfolio level.

Figure 3 illustrates the relationship between future 3-year excess returns and normalized price-earnings ratios from 1992 through 2018. Like in the interest rate risk exhibit above, the relationship between low volatility equity valuations today and their excess returns over the next three years is very low. Valuations need not be a deterrent to defensive equity investing.


Figure 3 3-Year Future Excess Return vs Normalized Relative PE Ratio

Investors need to evaluate whether valuations actually change the return profile of a defensive equity portfolio. Their focus should be on the role of defensive equity strategies in a portfolio: to reduce volatility and reduce drawdowns. Outperforming cap-weighted benchmarks is a complementary, long-term objective. Investors can view it as a bonus.

Aren't These Strategies Subject to Overcrowding Risk?

Persistent exposure to defensive stocks can result in high concentrations in individual sectors, countries, factors or stocks, which might trigger a liquidity squeeze and sharp price declines in a sudden selloff. Diversification is still important in defensive equity investing. Some naïve, ranking-based strategies may be more susceptible to overcrowding risk than covariance-optimized approaches or “managed volatility” strategies that limit exposure to these risks.


Figure 4 Interquartile Range of Returns for Global Low Volatility Strategies


What’s more, the diversity of investment approaches in the category results in dissimilar holdings and performance dispersion across defensive equity strategies. Investors who appreciate the differences in strategy design can circumvent overcrowding by avoiding oversubscribed strategies or diversifying their exposure.

How Will These Strategies Affect My Risk Budget?

Lower absolute risk will affect active risk budgets. Defensive equity strategies tend to have high tracking error to cap-weighted benchmarks given their low beta profile. Consequently, the optics of adding defensive equity allocations to a portfolio can be a problem for investors who desire equity portfolios with tracking errors tightly managed to a cap-weighted benchmark.

Figure 5 demonstrates the variation of active risk over time. Increased market volatility tends to coincide with market drawdowns. During these periods, as seen at the end of the bubble in 2000 and the global financial crisis in 2008-2009, active risk for defensive equity investing typically rises as benefits of their absolute risk reduction take hold. 


Figure 5 Hypothetical Global Low Volatility Tracking Error to MSCI World Index

On the other hand, to the extent defensive equity strategies reduce volatility, they potentially lower tracking error to future liabilities.

It's Not Too Late

Despite the massive drawdown in global equity markets, it’s never too late to add defensive equities to any portfolio. These are not market-timing strategies; rather, investors should consider them part of a long-term policy allocation. Building resiliency to equity market gyrations has important long-term compounding effects. We invite you to learn more in our eBook: An Institutional Investor Guide to Defensive Equity Investment.

A Guide to Defensive Equity Investing  Add resiliency to your portfolio. Download eBook


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.