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The Journal of Index Investing recently featured a paper on evaluating defensive equity strategies. Okay, it’s our paper. We’re flattered, of course, but what’s more important is the timing of their feature, given the number of record highs we’ve seen in equity markets this year.

Why Defense Matters

If your actuarial targets continue to necessitate significant equity exposure, then the Journal’s article is definitely worth your time. Defensive equity strategies offer you a way to maintain – even increase – equity exposure without the corresponding increase in risk. They seek market-like returns, lower volatility, and greater downside protection across a full market cycle. Selecting the right active manager potentially adds even more value.

These are essential attributes in volatile markets because if your equities are a liquidity source for your plan, withdrawing capital in down-markets to pay benefits can have devastating consequences on your funded status. It leaves less capital for future growth.

To demonstrate the cumulative impact of this threat, we only have to look at the first decade of the millennium. 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.

Using hypothetical equity portfolios, you can see the impact of capital withdrawals during that period (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%. On the other hand, 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.

Adding Active to Min Vol Can Enhance Funding Levels When Its Needed Most

What’s more, an active strategy designed to outperform Minimum Volatility Indexes can offer more potential. As shown above, the hypothetical U.S. and global strategies producing consistent excess returns above their minimum volatility benchmarks 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.

Selecting Your Defensive Line-up Isn't Easy

If the growing assets and variety of defensive equity offerings 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

The Intech paper spotlighted in the Journal of Index Investing offers a way to alleviate 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. Get complimentary access to the article for a limited time.

Intech Featured in The Journal of Index Investing Get Complimentary Access

 

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.

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