In our last blog, we illustrated how the worst periods of defensive equities’ underperformance relative to a cap-weighted benchmark have generally preceded significant drawdowns of this benchmark, and significant subsequent outperformance of defensive equities. The performance contours, however, are not always quite so highly correlated. In fact, in many instances of moderate up-markets, defensive equities have done just fine. In the chart below, we show that in periods when the market is up between zero and 10%, defensive equities actually outperform the market, on average. It’s only in much more sharply rising markets that we expect defensive equities to underperform.
Conversely, it’s not reasonable to expect defensive equities to outperform in every down month, quarter, and year. Rather, in the shortest periods, they may or may not provide immediate downside protection. What they have reliably delivered is measurable outperformance in the longer, more significant down-market events.
Our next chart illustrates the relationship between the length/severity of the drawdowns, and how defensive equity fares over the full peak-trough-peak cycle. The statistical relationship is strong (with R-squared values above 0.6): the longer and more severe a downturn, the more favorable the historical outcomes. This is why you want to preserve exposure to defensive equities through all markets. The next drawdown of this magnitude will likely not announce itself ahead of time, and the advantages that a defensive position may yield vs. a core allocation with a beta around one can be substantial.
In the real world, defensive equity can offer a diversifying presence and considerable improvement to risk-return outcomes when used alongside a core equity allocation.
To demonstrate this, we constructed a hypothetical passive equity allocation of one-third defensive (the MSCI World Minimum Volatility), and two-thirds core (the MSCI World), rebalanced annually at the beginning of each calendar year.
In this final exhibit below, the results over the maximum history available show that, although the annualized returns are similar (8.68% vs. 8.58%), there’s a significant reduction in volatility. As a result, the Sharpe ratio is improved from 0.37 to 0.42. As we discussed above, while there are some periods where defensive may seem like a drag, over the full cycle there is a meaningful reduction in risk, without sacrificing returns.
A lower volatility portfolio with greater drawdown protection at the same return can have multiple benefits – for multiple kinds of investors – including:
Defined Benefit Plans
Defined Contribution Plans
Endowments and Foundations
It’s understandable that investors may have grown skeptical of the benefits of defensive equities in recent years. While they paid off during the last major global equity drawdown, it’s been over a decade since they’ve seemed worthwhile, as central banks and fiscal spending have propped up global markets through what might have otherwise been devastating macroeconomic headwinds. What brief drawdowns we have seen since the GFC have rebounded so quickly that defensive equities haven’t seen scenarios conducive to working their magic, and many investors may be wondering: what’s the point?
While this is a fair question, we believe investors doubting the utility and efficacy of this asset class are ignoring history at their own peril. While equity investors have been fortunate to realize a relatively smooth ride upward against all odds, the evolving geopolitical landscape and the likely stimulus hangover should remind investors that all good things may come to an end. A defensive component in their equity allocation may be the best way to avoid or lessen the sting.
Defensive equities may have struggled recently, with the largest gap to their cap-weighted counterparts that we've seen. However, we have seen these levels before, and what followed may be of interest. Download the full paper to see what happened next.
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The views presented are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions.
Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. As with all investments, there are inherent risks that need to be considered.
Hypothetical performance results presented are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.
There is no guarantee that any defensive equity strategy will outperform a benchmark over the long term with lower volatility. These strategies may underperform the benchmark during certain periods of up markets and may not achieve the desired level of protection in down markets.
Indices are not available for direct investment; therefore, the performance shown does not reflect the expenses associated with the active management of an actual portfolio. Index returns include the reinvestment of dividends and other earnings.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by MSCI.