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As a market share leader in defensive equity investing,1 we’ve heard the gamut of issues raised on this topic by clients and consultants. After all, equity returns with less volatility is an alluring proposition. There must be a price to pay. There must be other risks to consider.

This is a reasonable reaction, so we thought we’d take the time to summarize the six most common issues mentioned when considering defensive equity investing.

Setting Realistic Expectations

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 beta 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.


MSCI World Index vs Hypothetical Global Low Volatility Strategy


Realizing Higher and Lower Tracking Error

Defensive equity strategies typically have high tracking error to cap-weighted benchmarks and low beta. 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. On the other hand, to the extent defensive equity strategies reduce volatility, they potentially lower tracking error to future liabilities.

Selecting Benchmarks

Using a low volatility index as a benchmark for defensive equity strategies seems like an obvious decision, but it’s less than straightforward under closer scrutiny. For one thing, which index approach is valid? It’s arbitrary to endorse one index over another given the wide range of construction methodologies. These so-called indexes are actually active strategies – they all have distinct stock selection processes, often have wide return dispersion and some even lack transparency.

Instead, many defensive equity investors simply use cap-weighted benchmarks and Sharpe ratio or Jensen’s (beta-adjusted) alpha to evaluate performance. Investors prefer Sharpe ratio if total volatility – both systematic and idiosyncratic risks – is most relevant. If only systematic risk is relevant, then Jensen’s alpha may be more appropriate. This practical approach recognizes that defensive equity investing isn’t about beating a defensive equity index; rather, it seeks a superior risk-return profile to cap-weighted benchmarks.

Interest Rate Risk

Many investors suspect that defensive equity stocks are nothing more than “bond proxies,” sensitive to interest rate movements. They are concerned about defensive equity strategy performance in rising rate environments since 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. Over the longer-term time horizons, the sensitivity of defensive strategies to interest rate changes tends to decrease, especially for portfolio-optimized and variable-beta approaches that do not simply rely on holding defensive stocks.

Valuation Risk

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. 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.

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.

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.

Learn More

The longest bull market in history, persistently low interest rates and increasing longevity are driving many to take a hard look at defensive equities investing. That’s why we’re offering a fresh look at defensive equity investing: How to Make Equity Allocations More Resilient.

 

How to Make Equity Allocations More Resilient  A fresh look at defensive equity investing. Download Paper

 

Rank based on data from the eVestment Alliance databases as of December 31, 2018, and include all active equity strategies where the primary investment approach is equal to “quantitative.” The number of managers includes those with at least one strategy in each group. Low Volatility Equity includes strategies in the All Low Volatility Equity Universe and included 47 managers.

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.