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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.)


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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.

Footnotes

1Source: eVestment Global Large Cap Core Universe as of January 15, 2019. There are 122 strategies (including GDE) in the eVestment Global Large Cap Equity Universe that have 5 years of history and are hence included in the scatter, however the full universe includes 255 as of the date mentioned. The GDE performance shown is of a composite consisting of all discretionary accounts using this investment strategy. The above information is considered supplemental to the GIPS presentation for this Composite, which can be found in the Appendix or was previously presented. A GIPS presentation is also available upon request. Returns greater than one year are annualized. Returns represent past performance and are not a guarantee of future results. Current performance may differ from the performance shown. Returns shown are asset - weighted using Composite member market values, where the Composite member's return calculations are time-weighted and reflect the reinvestment of dividends and other income. These performance figures are provided gross of fees and expenses other than actual trading fees and expenses, and reflect all items of income, gain, and loss. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income and the reinvestment of dividends (net of withholding tax rates) and other income. Performance is calculated in US dollars.

2 Source: SSGA, MSCI. Returns greater than one year are annualized. Returns represent past performance and are not a guarantee of future results. Current performance may differ from the performance shown. Returns shown are asset — weighted using Composite member market values, where the Composite member's return calculations are time-weighted and reflect the reinvestment of dividends and other income. These performance figures are provided net of management fees and expenses, and reflect all items of income, gain, and loss. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income and the reinvestment of dividends (net of withholding tax rates) and other income and are calculated in US dollars. It is not possible to invest directly in an index. Performance returns are calculated in US dollars.Without Defensive Allocation: 70% MSCI World Index, , 30% MSCI Emerging Markets, and 40% Barclays Global Agg. Index rebalanced monthly.

With Defensive Allocation: 33% Representative Active Defensive Strategy, 9% MSCI Emerging Markets, and 40% Barclays Global Agg. rebalanced monthly check footnotes here

Returns greater than one year are annualized. Returns represent past performance and are not a guarantee of future results. Current performance may differ from the performance shown. Returns shown are asset — weighted using Composite member market values, where the Composite member's return calculations are time-weighted and reflect the reinvestment of dividends and other income. These performance figures are provided net of management fees and expenses, and reflect all items of income, gain, and loss. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income and the reinvestment of dividends (net of withholding tax rates) and other income and are calculated in US dollars. It is not possible to invest directly in an index. Performance returns are calculated in US dollars.

Glossary

Valuation: Valuation is the process of determining the current worth of an asset or a company. There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business's management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets.

Disclosures

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Important Risk Information

Actively managed funds do not seek to replicate the performance of a specified index.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer‐term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

The views expressed in this material are the views of Kishore Karunakaran through the period ended March 12, 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.

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