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A leading U.S.-based consultant recently asked us to answer some great questions they had about low volatility, or defensive equity investing. We thought we’d share our answers more broadly because investors of all types frequently ask similar questions. The questions generally fall into one of five categories:

  • Objective of low volatility equities in the equity structure

  • Optimal allocation relative to the total equity structure

  • Ideal implementation: passive or active

  • Appropriate benchmark for measuring success

  • Drivers of active performance vs. a passive implementation

What’s the Primary Objective for Adding a Low Volatility Equity Allocation in the Equity Structure?

Low volatility equity strategies, and defensive equity more generally, seek equity market participation with lower volatility and downside protection. They attempt to win more by losing less. Therefore, the primary objective for allocating to a low volatility strategy is to reduce the volatility of the total equity structure and improve risk-adjusted returns, or performance efficiency.

Improving performance efficiency potentially addresses a wide range of needs for DB and DC plan sponsors:

DEFINED BENEFIT PLANS

  • Maintains equity exposure and reduces or reallocates a desired risk budget

  • Increases equity exposure and maintains a risk budget

  • Increases liquidity by replacing the alternatives used to reduce volatility

DEFINED CONTRIBUTION PLANS

  • Encourages participants to stay in the market longer
  • Mitigates temptation for market timing
  • Nurtures more consistent contributions
  • Improves target-date fund outcomes

Dig Deeper: A Guide to Defensive Equity Investing

How to Make Equity Allocations More Resilient: A Guide to Defensive Equity Investing
The longest equity bull market in history, persistently low interest rates and increased longevity have sparked renewed interest in defensive equity investing. Defensive equity strategies now comprise a mature category, which demands a fresh look: what is a defensive equity strategy, why does it deliver, what are the risks, and what’s the point?

What’s the Optimal Allocation for Low Volatility Strategies Relative to the Total Equity Structure and What’s Your Rationale?

Your plan objectives (e.g., funding status) are an important determinant of the optimal allocation to defensive equity strategies. There’s no one answer; however, generally, we believe a helpful framework for exploring this question is the tradeoff between the maximum drawdown and potential upside you’re seeking because it informs the type of defensive equity strategy you might implement which, in turn, guides your allocation decision.

All defensive equity managers seek to make this tradeoff asymmetric, but not all defensive equity strategies are the same. Investors often use the terms “low volatility” and “managed volatility” interchangeably, but we recommend categorizing these strategies by their defensive equity objective:

  • Minimizing volatility with cap-weighted, equity-like returns

  • Reducing volatility while seeking alpha

These two variants of defensive investing affect the allocation differently. The former objective is to capture equity market-like returns with considerably lower total risk. The latter objective may not achieve similar levels of risk reduction, but seek to provide alpha to close the spread between the expected long-term return on plan assets and the beta return from strategic assets.

Regardless of the type of strategy you consider, your allocation should complement your plan’s risk and return objectives and active risk contribution from your managers. Based on our research, the allocation within the overall equity structure needs to be large enough to start having a meaningful impact in risk reduction from either type of strategy.

We recognize, however, that sufficient validation of and conviction in any strategy plays a part in allocation levels; therefore, we recommend taking a stepped approach to defensive equity strategies. A minimum allocation of 5% of the equity structure is necessary to have influence on the overall plan. In our experience, however, most plans will begin seeing a meaningful impact on performance efficiency as it approaches a one-third allocation of the equity structure. Plans in de-risking mode could potentially replace 100% of their passive equity allocation.

Dig Deeper: What Type and How Much Should You Implement?

Evaluating and Implementing Defensive Equity Strategies
Defensive equity strategies have obvious appeal, but how do you get the most out of their potential benefits? We look at how to best differentiate between the multitudes of approaches, evaluate and classify them by outcome, and implement them within your equity allocation and overall portfolio.

Can Strategic Asset Allocations Adapt to Markets?
Investors in strategic asset allocation models aren’t immune to market drawdowns. This paper shows a path for potentially changing this experience. By using variable beta strategies, portfolio managers can make their allocation models more dynamic without changing their long-term risk and return assumptions.

What is the Ideal Implementation: Passive or Active? Why?

Intech believes there is no true passive implementation for defensive equities; rather, index-based industry solutions are systematic, rules-based strategies engineered to create lower volatility. That sounds like active management to us; they just have lower turnover. Therefore, relative to these “passive-like” strategies, we believe true active management offers potential to capture more volatility reduction, better downside protection, and higher upside returns.

You will find considerable differences in passive-like defensive indexes – not only in design, but also in their holdings, level of volatility reduction, and downside protection; also, their returns have a great degree of variability. There is strong evidence that defensive equity investing is not a generic commodity based on some universally accepted principles. These are not like cap-weighted indexes.

What’s more, to make passive-like defensive indexes marketable for retail, high-volume investment vehicles, like ETFs, they must place limitations on their designs to ensure transparency and liquidity. These limits potentially introduce a number of shortcomings:

  • No explicit target or control for return in their construction. For example, some passive-like implementations rely on a popular risk model in the portfolio construction process that minimizes portfolio risk subject to multiple constraints; yet there is no attempt to target or control returns. 

  • Inadequate risk reduction potentially arises during periods of market stress for a number of design limits: overly constricted risk exposures, reliance on a single time-scale for measuring risks and correlations, or the dependence on naïve, off-the-shelf risk models.

  • Infrequent rebalancing and updates of risk estimates are suboptimal in a changing market environment. Passive-like implementations often reconstitute (re-optimize) and rebalance over fixed periods. Re-optimizing and rebalancing infrequently may be slow to adapt to changing market conditions. 

  • Overly transparent and predictable trading patterns encourage predatory trading. As money flows into underlying instruments (i.e., ETFs) that follow these indexes, 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. 

  • Overcrowding risk is more apparent with violent swings in performance. Since volatilities and correlations between stocks tend to change over time, a regime in which correlations between commonly held low volatility stocks is high can severely hamper the ability of such strategies to provide a prudently diversified portfolio and downside protection. 

A truly active defensive equity strategy has the flexibility to avoid these shortcomings; indeed, perhaps the best proof-point for our argument is an active strategy benchmarked to one of these naïve, rules-based defensive equity indexes.

Dig Deeper: Defensive Equity Indexes

Making Sense of Defensive Equity Indexes
Several major equity benchmark providers maintain rules-based defensive equity portfolios they call indexes – but they shouldn’t be confused with their cap-weighted counterparts. We take a closer look at them, including their differences, viability as passive investments, potential for improvement, and how to best measure active defensive equity strategies.

How a New Benchmark Adds to Defensive Equity Strategy Evaluation
Featured in the Journal of Index Investing, this paper demonstrates using MSCI Minimum Volatility Indexes to aid in defensive equity strategy evaluation. Defensive equities can be a prudent allocation, but evaluating them against cap-weighted benchmarks can eviscerate your active risk budget. Despite some limitations, MSCI’s Minimum Volatility Indexes can solve this problem: retain the opportunity to benefit from defensive equity investing while evaluating your solution in a risk framework that works for you.

What’s the Most Appropriate Benchmark for Measuring Success? Why?

We know that defensive equity strategies attempt to provide exposure to equity markets with less volatility and greater downside protection when compared to cap-weighted benchmarks, but we also know their performance will substantially deviate from the cap-weighted indexes in order to meet their objectives.

Short-term evaluations based solely on performance relative to a cap-weighted benchmark do not provide much insight into how well a defensive strategy meets its objective. A return comparison versus a cap-weighted benchmark is insightful when viewed over the long term; however, for short-term comparison, employing other risk and efficiency metrics such as standard deviation, beta, Sharpe ratio, and downside capture complements the relative return analysis nicely.

Using low or minimum volatility indexes as benchmarks would seem to solve the problem; unfortunately, they are no more an objective representation of defensive equities than any active management strategy. Most defensive indexes are passive-like defensive portfolios. Unlike cap-weighted indexes, which represent the collective wisdom of our capital markets, defensive equity indexes are systematic, rules-based strategies engineered to create lower volatility – much like any active approach.

Each defensive equity index has different construction methodologies and incorporates active implementation choices, including limits on individual stock, sector, countries, and factors, and constraints on turnover. As such, each have very different risk and return results. These indexes resemble active strategies more than objective benchmarks; thus, they are less suitable as a reference point for evaluating an (another) active strategy. Sometimes, however, we see plan sponsors use them as secondary benchmarks.

Consequently, we believe a deep understanding of defensive equity indexes is essential to make a suitable benchmark choice. At Intech, we use cap-weighted indexes for our low and adaptive volatility strategies; however, we use MSCI Minimum Volatility Indexes for our FactorPlus strategies.

INTECH LOW AND ADAPTIVE VOLATILITY STRATEGIES: CAP-WEIGHTED BENCHMARKS

These strategies aim to provide downside protection in down markets with upside participation in rising markets. They focus primarily on Sharpe ratio, differing in the magnitude of risk-reduction claims relative to a cap-weighted benchmark. We use a cap-weighted index as the benchmark for these strategies, allowing us to optimize the portfolio using the broad universe of stocks. This way, we are free from the self-imposed constraints inherent to the defensive indexes. Additionally, we open the opportunity set to all stocks in the universe, not just the defensive stocks as defined by the defensive indexes.

INTECH FACTORPLUS STRATEGIES: MSCI MINIMUM VOLATILITY INDEXES

Our FactorPlus strategies seek to outperform MSCI Minimum Volatility Indexes with the least amount of active risk. They focus on information ratio. Rather than employing a defensive equity investment process, these strategies rely on the indexes for their investment universe and defensive equity characteristics. These strategies allow you to benefit from defensive equity investing while retaining a familiar, active-risk evaluation framework.

Dig Deeper: Benchmarking Defensive Equities

Evaluating and Implementing Defensive Equity Strategies
Defensive equity strategies have obvious appeal, but how do you get the most out of their potential benefits? We look at how to best differentiate between the multitudes of approaches, evaluate and classify them by outcome, and implement them within your equity allocation and overall portfolio.

How a New Benchmark Adds to Defensive Equity Strategy Evaluation
Featured in the Journal of Index Investing, this paper demonstrates using MSCI Minimum Volatility Indexes to aid in defensive equity strategy evaluation. Defensive equities can be a prudent allocation, but evaluating them against cap-weighted benchmarks can eviscerate your active risk budget. Despite some limitations, MSCI’s Minimum Volatility Indexes can solve this problem: retain the opportunity to benefit from defensive equity investing while evaluating your solution in a risk framework that works for you.

What are the Key Drivers for Active Defensive Equity Strategies Under- and Over-Performing Passive Indexes in Recent Years?

While you may be attracted to long-term results for defensive equities, you should also have realistic expectations for shorter-term performance, and the key drivers for that performance relative to both cap-weighted and rules-based defensive equity indexes.

PERFORMANCE VERSUS THE BROAD MARKET INDEXES

Generally, the magnitude and duration of up and down equity markets can produce varying outcomes for defensive equity strategies. Most defensive equity strategies will lag the broader market in sharp upturns because their lower beta serves as a significant headwind to performance.

Even in drawdowns, their downside protection can 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.

We’ve experienced this environment in recent years – a strong bull market that’s seen only brief pullbacks. The current market has largely rewarded risk taking, especially for large-cap growth stocks. Defensive equity strategies with a lower volatility profile, smaller size exposure, and/or a greater value tilt should expect to lag.

Occasionally, there are more nuanced performance explanations. During the March 2020 drawdown, defensive low-beta stocks weren’t exempt from losses. There was an anomalous shift in equity betas across the market given the sharp decline in stock beta correlations and a narrowing of the overall beta spread. This unique phenomenon of sharply rising stock betas resulted in far fewer defensive stocks during a drawdown. Perhaps even more distinct was the unprecedented flight to safety to pandemic-immune, normally higher-beta stocks and industries, like Amazon and pharmaceuticals.

PERFORMANCE VERSUS DEFENSIVE EQUITY INDEXES

Relative performance of active defensive equity strategies to defensive equity indexes has been a mixed picture, but it’s important to remember that such an evaluation is like comparing active strategies to other active strategies. Defensive equity indexes are a heterogeneous group of systematic, rules-based strategies. Each index has different construction methodologies and incorporates active implementation choices. As such, each have very different risk and return results.

Drivers of under- and over-performance relative to defensive equity indexes will depend on the risk and return objectives of the active strategy and the investment approach for the index.

Objective: Minimizing volatility with cap-weighted, equity-like returns

Active strategies that primarily emphasize risk minimization may be less constrained than many rules-based indexes and potentially provide more resiliency. In the current bull market, these types of active defensive strategies would face stronger headwinds compared to their index counterparts. However, if the market experiences a sustained drawdown, these strategies offer the potential for greater downside protection.

Objective: Reducing volatility while seeking alpha

Other active strategies, like Intech Global Minimum Volatility FactorPlus, offer comparable levels of risk mitigation to defensive equity indexes yet strive for higher upside performance. For these strategies, the source of the active risk relative to the index will vary depending on the investment approach.

An investment approach may favor specific tilts towards factors, stocks, and segments of the market in pursuit of alpha. That can work for or against a strategy relative to the index. For instance, in recent markets, smaller size or value exposures have served as performance detractors versus defensive equity indexes.

Over the long-term, we believe more flexible active approaches that are adaptive and embed a reliable alpha source can outperform more constrained defensive equity indexes. These types of active approaches offer the added ability to avoid some of the common pitfalls associated with naïve, rules-based processes: susceptibility to crowding effects, inadequate downside protection in turbulent market environments, and lack of a reliable alpha source.

Dig Deeper: Performance Expectations

A Guide to Defensive Equity Investing
The longest equity bull market in history, persistently low interest rates and increased longevity have sparked renewed interest in defensive equity investing. Defensive equity strategies now comprise a mature category, which demands a fresh look: what is a defensive equity strategy, why does it deliver, what are the risks, and what’s the point?

Making Sense of Defensive Equity Indexes
Several major equity benchmark providers maintain rules-based defensive equity portfolios they call indexes – but they shouldn’t be confused with their cap-weighted counterparts. We take a closer look at them, including their differences, viability as passive investments, potential for improvement, and how to best measure active defensive equity strategies.

 

The information, analyses, and/or opinions expressed are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor, have been presented for general informational purposes only, and do not purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained herein. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. The information analyses, and/or opinions expressed are subject to change based on market and other conditions, and should not be relied on as the sole basis for investment decisions.

Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. The value of an investment may go down as well as up and you may not get back what you originally invested. Information that is based on past results or observations is not necessarily a guide to future results, and no representation or warranty, express or implied, is made regarding future results.

There is a risk/reward trade-off that comes with investing in defensive equity strategies. These 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.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data and/or references contained herein. This material has not been approved, reviewed, or produced by MSCI.