Defensive equity indexes are often examined within the context of their potential as investable ‘passive’ portfolios. But before Jack Bogle helped put the index fund on the map, indexes were primarily meant to measure the market, and by extension, the success of an active manager in beating it. Beyond cap-weighting, growth and value indexes are still commonly used as measuring sticks for managers committed to that style. It begs the question: are defensive equity indexes generally suitable for measuring the success of a defensive equity strategy?
Are they really benchmarks?
In some cases, an investor may decide to employ a third-party defensive index as a (relatively) transparent, objective benchmark of defensive equity investing for their overall portfolio. Consequently, they may seek a strategy specifically designed with the objective of maximizing its information ratio relative to this benchmark, like many traditional active strategies do versus a cap-weighted index. In those cases, said index would be the natural, obvious performance benchmark.
In most other cases: no, it’s not. Defensive equity indexes are characterized by underlying assumptions and active implementation choices, many of which are indistinguishable to those made by quantitative or fundamental active managers. As such, they resemble active strategies in many ways, and we don’t believe it’s appropriate to benchmark an active strategy with another active strategy.
Most commonly, defensive equity managers focus on maximizing risk reduction and/or increasing their Sharpe Ratio. As a result, a defensive equity manager with compelling risk reduction over time may have lower total returns relative to low volatility indexes in rising equity markets (although some of this risk can be mitigated by adopting a dynamic beta reduction). At any rate, there are alternatives that better evaluate the net added value of defensive equity managers.
The Logical Long-Term Approach: Risk/Reward vs. the Market
Over longer periods – ideally a full market cycle – many of the usual risk and return metrics relative to the relevant cap-weighted index are appropriate and useful. Which of these metrics are prioritized will largely depend on the manager’s stated strategy objective and, perhaps more importantly, the investor’s objectives in deploying said strategy. Standard deviation and, specifically, the level of volatility reduction (e.g., “30% less risk than the index”), Sharpe ratio, Jensen’s alpha, downside capture, etc., all have their place.
Unfortunately, even though defensive equity strategies are a growing industry segment, nearly all of them are still under a decade old, and the last major volatility event occurred more than a decade ago (and acted as the trigger for renewed interest in defensive equity). As a result, full market cycles are largely only accessible to analysis via backtests, and live track records are usually shorter than are appropriate for some of these measures. Critically, these track records likely lack the inclusion of any truly significant market declines in which you can evaluate if you’re really getting what you’re paying for.
An Adaptable Alternative: Customize Your Own Yardstick
Over shorter periods, particularly those of extreme rising markets, these defensive strategies may be expected to lag, and lack the opportunity to make up those shortfalls on the downside. Short of writing them off during those periods as irrelevant, there is one alternative: a custom defensive equity benchmark.
If the goal of a benchmark is indeed to assess the value of an active manager and defensive equity strategies attempt to reduce the volatility of equity portfolios, then why not compare an actively managed defensive equity strategy to a naïve defensive portfolio which can be easily created passively? For example, if a low volatility strategy has a beta of 0.7, investors can easily create a portfolio with comparable beta on their own by investing 70% of their funds in the market (i.e., a cap-weighted index) and 30% in cash (i.e., treasury bills). Rebalancing the capital in this notional low volatility portfolio on a monthly basis creates a stream of returns, which can in turn be used to benchmark a live defensive equity strategy by computing its information ratio relative to this custom benchmark.
This approach can be taken several steps further where it’s adjusted dynamically to take into account changes in the risk reduction provided by the active strategy. For example, rolling 12-month beta can be used to determine the amount of stocks vs. cash invested in the custom portfolio during the upcoming month. An alternative to trailing beta is the trailing ratio of standard deviation of returns of the active strategy vs. the standard deviation of returns of the cap-weighted index. This might be preferable if the investor cares more about reducing total volatility, rather than reducing systematic (market) risk.
The ideal custom portfolio may be different for each active manager, and it can be complicated for an investor using multiple managers within a defensive equity allocation. One way to avoid this is to revert to using a fixed ratio, such as the 70%/30% example illustrated above, or a ratio based on a target volatility reduction. Regardless of whether a static or dynamic ratio is used, the approach of a custom benchmark based on a ‘homemade’ defensive equity benchmark can be a useful and flexible approach to evaluating active defensive equity strategies over both the shorter and the longer term.
In this age of equity indexing, many think of them less as points of reference for performance (or risk) and more as paths to passive exposure. How well do you know prevailing defensive equity indexes and their expected outcomes? Are defensive equity indexes good enough for your portfolio’s objectives, or can you do better? Learn more about our defensive equity offerings here.
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