The growth in assets within defensive equity strategies over the past decade since the last financial crisis is evidence of demand for such positioning from investors – and their recognition of the impact it can have on equity portfolios. We’ve covered the potential benefits of defensive equity strategies at length in previous papers, but to summarize: market-like (or better) returns, with greater downside protection and reduced volatility (standard deviation).Low volatility indexes, such as MSCI’s Minimum Volatility suite, are considered a common passive entry point for low volatility exposure. In our previous blog post, we discussed the limitations of low volatility indexes, and how active management can improve their outcomes.

While low interest rates have been a contributor to the historically strong period of equity market returns, they have also been a drag on funding statuses. And with return targets 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. The compounding of reduced drawdown with added excess return during the worst periods markets have to offer can be the difference between solvency and default for plans without a surplus to burn. Adding potential excess return via an active manager represents even more value preserved in turbulent times.

To demonstrate the cumulative impact this can have on funding levels, 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. With two massive drawdowns in U.S. and global equities and the start and end of the decade, it 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.

How Active Can Help

Equity exposure is essential to close funding gaps, but market drawdown risks are real. So-called “passive” low volatility indexes appear to be a straightforward solution, but have shortcomings by design. We think an active manager can do better. Learn more by downloading our eBook, “How to Improve Low Volatility Factor Investing Outcomes.”

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Hypothetical performance shown is 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. 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 hypothetical results shown.
In no circumstances should the hypothetical results be regarded as a representation, warranty, or prediction that investors will achieve or are likely to achieve the results displayed or that investors will be able to avoid losses. The hypothetical results include estimated trading fees, but do not reflect the deduction of advisory fees and other expenses, which will materially lower results over time. As with all investments, there are inherent risks that must be considered.
An index is unmanaged, is not available for direct investment, and does not reflect the deduction of management fees or other expenses. There is a risk/reward tradeoff that comes with investing in defensive equity strategies. These risk strategies are likely to underperform the index during periods of strong up markets and may not achieve the desired level of protection in down markets.
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