What an 80:60 Equity Strategy Can Teach Investors as Market Volatility Rises
Defensive equity strategies seeking to participate substantially in up markets while limiting exposure to market downsides (i.e., approximately an 80:60 ratio of upside to downside capture) can significantly outperform their benchmarks.
Our analysis, stretching back to 1900, shows that an 80:60 defensive strategy can outperform the benchmark not just over the span of many years, but also over a more practical, decade-by-decade investment horizon.
Many commonly used approaches to equity portfolio construction assume that, over time, returns on financial assets will cluster symmetrically within a small range of the mean. In practice, however, the distribution of returns has not followed this “normal” distribution pattern. Instead, returns on assets tend to be “fat-tailed,” with far more instances of extreme losses and gains than a normal distribution would predict. Unfortunately, large losses can impair investment prospects for months and even years. Defensive equity strategies attempt to combat this problem. With their dual return and risk mandate, defensive strategies seek substantial participation in market upsides while limiting exposure to market downsides – an approach that can help investors realize the normal distribution patterns they expect.
The 80:60 Strategy since 1900
A defensive strategy’s upside/downside capture ratio measures the degree to which it has gained or lost relative to an index. An “80:60” strategy is constructed to participate in 80% of up markets and 60% of down markets. This capture ratio is typical of State Street Global Advisors’ defensive equity strategies.
The risk and return outcomes of an 80:60 strategy can vary substantially from those of an index. Consider the 119-year history of the Dow Jones Industrial Average (DJIA), consisting of 1,435 monthly observations since 1900. Of those, 58% of the monthly returns were positive; 42% were negative. The average monthly return during positive months was 3.73%, while the average monthly return during negative months was -3.85%.
Two notable points emerge from this analysis. First, at 42%, the proportion of negative monthly returns is much higher than many investors might expect. Second, there is a noticeable degree of asymmetry in average returns between the up and down months; in other words, on average, markets sink lower when they’re down than they rise when they’re up.
This combined phenomenon can significantly impair overall outcomes over time – but our analysis shows that a portfolio with 80% upside participation and 60% downside participation can indeed yield significant improvement in both returns and risk.
For example, 80% upside and 60% downside participation in the DJIA over 1,435 months (until July 2019) would yield annualized returns of 8.74%, compared to 5.16% for the DJIA alone. In fact, the gap between index performance and the 80:60 strategy’s performance on returns progressively widened, as the asymmetry in negative versus positive returns compounded over time. And from a risk perspective, total annualized volatility of the 80:60 portfolio was only 12.74%, compared to 18.09% for the DJIA. This represents a relative risk reduction of nearly 30%.
The 80:60 Strategy, Decade by Decade
Investors working within the span of a career – rather than a span of more than a century – may well ask whether the 80:60 approach can contribute to positive outcomes over a practical investment horizon.
When we break this 119-year period down into decades, we observe that the model 80:60 strategy tends to outperform in terms of returns in almost all decades.1 (See Figure 1.) In general, the model 80:60 strategy was most effective in delivering excess returns during decades with the highest volatility and the greatest proportion of down months. Importantly, though, from a risk perspective, the volatility of the model 80:60 strategy is consistently lower than the index across all decades.
It is worth noting that the 10-year period ending July 2019 has seen historically low levels of market volatility, which has made it more difficult for a defensive, 80:60 portfolio to outperform the market. Even so, the 80:60 strategy outperformed the market over that time frame.
Achieving an 80:60 Outcome
To construct a defensive equity portfolio that achieves an 80:60 capture ratio, we believe it is important to consider the return and risk characteristics of individual stocks in terms of value, quality, and investor sentiment (including price momentum). In general, we find that companies with low volatility, good value (e.g., high dividend yield, high earnings to price, high cash flow to price), high quality (e.g., low balance sheet accruals), and high momentum (e.g., last year’s winners) tend to outperform their peers – and therefore are strong candidates for inclusion in an 80:60 strategy.
The Bottom Line
Our analysis suggests that a defensive strategy seeking to maximize risk-adjusted returns over time may have a substantial advantage over the index. By avoiding some downside participation while continuing to pursue a large proportion of available upside, defensive equity strategies can create compelling return streams while performing well in both up and down markets.
1 The only exceptions occurred in the 1950s and 1990s. In each case, the underperformance was only minor (by 0.1% in 1950s and by 0.3% in the 1990s).
Defensive equities: While the term is generally used in connection with stocks that possess defensive characteristics, such as stable cash flows and lower volatility, it may also be used to refer to lower-risk securities such as government bonds and preferred shares. Defensive stocks may outperform their flashier counterparts like growth stocks during periods of economic uncertainty when equity markets display a declining trend, but will underperform during periods of economic expansion.
Investing involves risk including the risk of loss of principal. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
Hypothetical Portfolio Methodology: Sample portfolio returns shown in Figure 1 are hypothetical and are based on the returns of the underlying market indices in the proportions shown above. The returns of the “80:60” strategy were achieved by multiplying positive monthly returns by 80% (0.8) and negative monthly returns by 60% (0.6). Months with performance of 0% remained as such.
The views expressed are the views of Adhiraj Mallik and Orhan Imer through August 31, 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal.
Actively managed funds do not seek to replicate the performance of a specified index. Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
The MSCI World Index, MSCI World ex US and the MSCI US Index are trademarks of MSCI Inc. MSCI indices are the exclusive property of MSCI Inc. (“MSCI”). MSCI and the MSCI index names are service mark(s) of MSCI or its affiliates and have been licensed for use for certain purposes by State Street Global Advisors (“SSGA”). The financial securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such financial securities. No purchaser, seller or holder of this product, or any other person or entity, should use or refer to any MSCI trade name, trademark or service mark to sponsor, endorse, market or promote this product without first contacting MSCI to determine whether MSCI’s permission is required. Under no circumstances may any person or entity claim any affiliation with MSCI without the prior written permission of MSCI.
For use in EMEA:
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
This communication is directed at professional clients (this includes eligible counterparties as defined by the appropriate EU regulator) who are deemed both knowledgeable and experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including retail clients) should not rely on this communication.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
You should obtain and read a Key Investor Information Document and Prospectus relating to the SSGA Cash funds prior to investing. Further information, including the annual and semi-annual reports and the Key Investor Information Document and Prospectus describing the characteristics, charges, expenses and risks involved in your investments are available for residents of countries where SSGA cash funds are authorized for sale, at www.ssga.com/cash and from your local SSGA office or by calling +44 (0)20 3395 2333.
Investing involves risk including the risk of loss of principal. It is possible to lose money by investing in the funds.
Before investing, carefully consider a fund's investment objectives, risks, charges and expenses. Click the link to obtain a prospectus which contains this and other information, or by calling +44 (0)20 3395 2333, please read it carefully before investing.