How Defensive Equities Can Contribute Value Across Varying Market Environments
This is the second piece in our series, Getting to 7%, which explores the challenges investors currently face in reaching 7%+ total portfolio return. Read the first piece in the series here.
In recent years, equities have been a key source of return to institutional investors. Equities can be one of the biggest contributors of risk to investors’ overall risk/return profile, especially in times of market distress. With government bond yields stuck at low levels, investors seeking to reduce risk by shifting from equities to bonds may find that bonds provide inadequate shelter under current market conditions. Although bond markets may provide some protection from risk, in the current environment, this shield may come at the expense of returns. This means that maintaining a substantial allocation to equities may remain crucial to achieving return goals, even as rising equity-market volatility increases the risk of substantial drawdowns.
How can pension plans achieve consistent returns amid weakening return prospects and increasing equity-market volatility, if equities must remain a key driver of those returns? One potential answer involves increasing the allocation to equities, while simultaneously taking an actively managed defensive position within that equity allocation. That defensive position would aim to manage risk while seeking returns. This active approach creates the potential for harnessing the return prospects of equities without driving up total portfolio risk.
Managing total returns and total volatility
In Active Quantitative Equity at State Street Global Advisors, we believe that a flexible, nuanced and robust approach to defensive equities, with a dual objective of pursuing alpha while preserving capital, is the most effective one. When selecting defensive stocks, we believe it’s important to consider both risk and return, and to consider these attributes at the portfolio level. Just because a stock exhibits low price volatility doesn’t mean it’s automatically suitable for inclusion. We apply the same rigorous analysis, based on our core investment themes of value, quality and market sentiment, to our evaluation of stocks for inclusion in our defensive portfolios.
In addition, we believe that correlations among stocks and their contributions to the portfolio’s overall return and risk profile should be a key focus when designing defensive portfolios. This means that we explicitly manage total volatility in our defensive strategies (as opposed to tracking-error risk). This approach can produce defensive portfolios that are highly diversified, while preserving the potential to yield an even better outcome than other outperformance-seeking approaches. By combining active stock selection with volatility management, defensive equity strategies aim to elevate excess returns achieved per unit of total risk. (See Figure 1.)
Adding value through defensive equities
This opens the question: In practice, how does an investor’s return profile change with a defensive allocation? Our analysis suggests that over the past 10 years, taking a defensive posture would have added affirmative value across all time periods, not just when equity drawdowns are larger, but even when equity markets have done well. (See Figure 2).1
Additional analysis exploring key measures of risk and return performance also suggests that taking a defensive posture can improve overall risk-adjusted investment performance, in addition to reducing volatility. Our analysis shows that, over the past five years, volatility for a standard, representative 60/40, equity/fixed income portfolio was 7.53% per annum, compared with 6.71% per annum for a representative 60/40, defensive equity/fixed income portfolio. Perhaps more notably, the Sharpe ratio – a measure of risk-adjusted performance – for the standard portfolio was around 0.35 over the past five years, while the Sharpe ratio for its defensive counterpart was 0.57 – a considerable improvement.2
Investors face a challenging market environment – one in which conventional approaches to meeting return objectives while reducing portfolio risk may be inadequate. We believe that many such investors may find a fruitful path forward in a flexible, nuanced and robust approach to defensive equities that balances a dual risk and return mandate. By doing so, we believe they can improve their prospects for achieving returns objectives while preserving capital and avoiding undue risk.