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Today’s modern institutional portfolio is increasingly complex. Private equity, private debt, real estate, infrastructure, etc. are important asset classes to improve diversification and portfolio efficiency. But they are also less liquid. This creates the potential for funding status problems if equities become the primary source of liquidity in a downturn. Defensive equity investing offers the potential to help.

Your Challenge

The unintended consequence of today’s modern portfolios is that equities are now the primary source of liquidity for pension plans. Consequently, as volatility rises, so does the probability that pensions will need to sell equities in declining markets to pay benefits. This can be a self-perpetuating problem. As more plans are forced to sell equities to raise cash, it could lead to still lower equity prices – all the while paving the way for even greater funding gaps down the road.

Look Within

We, of course, would never argue with the pursuit of diversification, but instead of diversifying away from public equities, pension plans can diversify within their equity allocations to improve portfolio efficiency. More specifically, they can dial back their beta-risk exposure by making a policy allocation to defensive equity strategies.

There are two basic groups of defensive equity strategies based largely by their stated objectives. By adjusting allocations to one of these types of strategies, plan sponsors can reach a better balance between raising cash to fund immediate payouts while generating the returns they need to sustain their plans in the future.

Low (or Minimum) Volatility: Market-like returns with significantly lower risk. “Risk” may be defined vaguely or in varying ways, but typically portfolio volatility, either in absolute terms or relative to a cap-weighted index is the primary measure. While not necessarily static in terms of volatility reduction, they do not attempt to keep up with rising markets. Variable Beta: Better-than-market returns with lower, but dynamic, risk. While sacrificing some volatility reduction and maximum downside protection, they may strike a more core-like profile in stable risk regimes, with a beta approaching and even exceeding 1.

Low or Minimum Volatility and Variable Beta

Impact on Your Overall Portfolio

We’ve already demonstrated the possibilities for the addition of a defensive equity strategy within your public equity allocation, but this allocation doesn’t exist in a vacuum. So how does this affect outcomes at the overall plan level? Given the significant portion of global public equities in a large institutional portfolio, replacing even a third with a defensive equity strategy can still have a significant benefit to the risk/return profile and funding status.

In Figure 1, we examine the effects within a hypothetical example of a modern institutional multi-asset portfolio: 50% public equities, 30% bonds, 10% real estate, and 10% private equity, rebalanced annually. Comparing a 100% passive exposure to global equities versus those where we replace 1/3 of the equity allocation with a hypothetical low volatility or variable beta strategy, the results represent genuine value over time in terms of capital growth, with less volatility along the way.

Figure 1 - Effect of Replacing One Third of Global Equity Allocation

While we’ve kept the total public equity portion of the overall portfolio static in this example, the reduction in total portfolio risk frees up risk budgets for increased exposure to public equities or other return-seeking assets.

Learn More

Diversifying your portfolio by adding defensive equity strategies is clearly appealing, but managers use a variety of approaches to achieve those results. And a strategy name doesn’t tell the story. How do you distinguish between similar-sounding strategies? How does your tolerance for loss affect your allocation to defensive equities? You can learn more by downloading our paper entitled, “Evaluating and Implementing Defensive Equity Strategies.”

Evaluating and Implementing Defensive Equity Strategies  A deeper look at defensive equity investing. Download Paper


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