We’ve enjoyed a historically long bull market, but it can’t last forever, of course. Recent volatility shocks and increasing political uncertainty serve as a reminder that corrections are difficult to predict, and impossible to protect against after the fact. Defensive equity strategies offer a long-term, strategic option to potentially mitigate those risks and their impact on multi-manager equity line-ups is clear, but how much of it do you really need?
What's Your Loss Tolerance?
Asset owners can use defensive equity strategies to substitute for either passive cap-weighted indexes or active long-only portfolios benchmarked to a cap-weighted index. But unlike traditional active strategies, defensive strategies focus on volatility reduction and lower drawdowns; therefore, the amount you allocate to your portfolio should be based on your willingness to tolerate losses.
Figure 1 demonstrates the drawdown effects that incremental allocations to a low volatility or variable beta strategy may have on your equity allocation. Asset owners with a low tolerance for large capital losses should allocate more of their equity holdings to defensive equity strategies. For example, over the last 20 years an investor unwilling to tolerate losses exceeding 40% should have allocated over 60% of his or her equity holdings to a low volatility strategy or about 70% to a variable beta strategy.
New Frontiers
As seen in Figure 1, returns improved with incremental allocations to a low volatility or variable beta strategy. Combined with lower volatility, the higher returns offer higher Sharpe ratio potential. Yet, not all Sharpe ratios are created equally. Each of the two types of defensive equity strategies may improve it, but towards which part of the efficient frontier are they going to do so? Figure 2 demonstrates the effect incremental allocations to a low volatility or variable beta strategy may have on your risk-return profile when combined with a cap-weighted index allocation.
No Quick Fix
Of course, an investor’s time horizon matters too. The magnitude and duration of up and down markets can produce varying outcomes for these strategies. Most of these strategies tend to lag the market in sharp upturns because of the headwind faced due to beta lower than one. To make the most of their potential, asset owners should consider defensive equity strategies as part of their long-term policy allocation. These strategies are not short-term tactical solutions.
Learn More
Diversifying your equity allocation by adding defensive equity strategies is compelling, but managers use a variety of approaches to achieve those results. And a strategy name doesn’t tell the story. How do you distinguish between similar-sounding strategies? What’s more, how do they impact your overall portfolio? You can learn more by downloading our paper entitled, “Evaluating and Implementing Defensive Equity Strategies.”
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