3 Defensive Equity Indexes You Need to Know

With the increasing interest in reducing the risks of equity exposure and the so-called low volatility anomaly, investors have been looking for ”objective“ representations of such a portfolio. And the big three providers: S&P, Dow Jones, FTSE Russell, and MSCI have been more than happy to oblige. But are they interchangeable proxies for defensive investing, or unique approaches to portfolio construction that yield commensurately unique outcomes?

Contrasting Construction

Even a brief glance makes it obvious that unlike cap-weighted indexes, which generally feature similar construction methodologies, there’s a clear divergence in approaches here. Let’s get to know the major offerings:

S&P is perhaps the most straightforward, selecting the least volatile stocks and weighting them in inverse proportion to that same metric. FTSE’s Minimum Variance offerings are quantitatively optimized for lowest absolute volatility. So too are MSCI’s Minimum Volatility indexes, but MSCI applies different constraints, and combines its Barra Equity Models as part of the process. As you might expect, they can result in very different portfolios (see figure 2).

Results May Vary

Given the discrepancies in holdings, you might assume their performance results also differ significantly. You’d be correct, though you might not know it by looking at shorter periods or long-term annualized results. It’s the contours within those periods that best illustrate their variability over different market environments.

Let’s look at volatility first. Figure 3 plots the rolling 3-year volatility of U.S. and Global defensive indexes as well as an equivalent cap-weighted parent index.

While all show reduced volatility relative to a comparable cap-weighted index, it is clear that there can be substantial differences between the level of volatility reduction of the defensive equity indexes. This is especially apparent during periods of market stress, which is precisely the time when defensive equity allocations should be expected to earn their keep.

It may also be hard to know in advance which one will do better under which circumstances. As figure 3 shows, the MSCI USA Minimum Volatility Index was better at reducing volatility during the prolonged volatility spike associated with the bursting of the Technology bubble in 2000, whereas the S&P 500 Low Volatility Index was more resilient during the turbulence of the Global Financial Crisis.¹

Such differences also manifest as significant differences in returns – as seen in figure 4. This substantial variability in the short-term relative returns between the two pairs of U.S. and Global low-volatility indexes translates into a high tracking error between the portfolios.

The extent of the difference in volatility and returns between indexes of the same region, while purporting to have the same objective of reducing volatility, is strong evidence that defensive equity investing is not a generic commodity that can be replaced by some universally accepted passive substitute. Unlike cap-weighted indexing, the defensive equity index investor’s experience will vary considerably depending on their choice of index provider. The differences are as considerable as the differences in performance one might expect to experience between aggressive active managers and a cap-weighted index.

Can You Do Better?

Most defensive equity indexes are promoted as passive-like portfolios designed as an entry-level exposure to lower volatility stocks, but they commonly make concessions in construction in the interest of investability. Do these concessions represent an opportunity to improve upon their outcomes? How can an active manager do better? Learn more by downloading our paper entitled, “Making Sense of Defensive Equity Indexes.”