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Challenging equity markets have renewed interest in defensive equity investing – an important way to add resiliency to a portfolio. Such strategies bear a myriad of names: low volatility, managed volatility, minimum variance, low beta and variable beta. Even quality, value and dividend-focused strategies can fit the bill. 

This invites the question:

What is defensive equity investing?

Simply put, defensive equity investing seeks to improve risk-adjusted returns by avoiding uncompensated risk. Three performance outcomes best characterize defensive equity investing:

  • Reduced volatility
  • Reduced drawdown
  • Equal or better performance than cap-weighted benchmarks

How Do You Reduce Volatility Without Harming Returns?

Most of us understand that lower return generally requires less risk, but this is often confused with the false claim that less risk will result in lower return. As seen in Figure 1 below, low-volatility stocks have historically offered better returns per unit of risk than high-volatility stocks.

 

Figure 1_Annualized Monthly Returns for Stocks Grouped by Volatility Quintile

 

Because equities are a large contributor to portfolio risk, this relationship has implications on asset allocation, risk budgeting and liquidity management.

Classifying Approaches to Defensive Equity Investing

To help investors map today’s defensive equity landscape, we offer an imperfect, but practical, framework. Defensive equity strategies typically fall into one of three groups: rank-based, portfolio-optimized and variable beta.

Rank-Based
These strategies take a stock-centric approach that identifies and holds a subset of a universe of stocks based on their individual risks (e.g., volatility or beta). It does not target a level of return, or risk reduction.

Portfolio-Optimized
Focused on portfolio outcomes, these strategies attempt to account for stock return correlations. Optimization is dependent on covariance matrix estimates and constraints, and often targets a constant level of risk reduction.

Variable Beta
These defensive equity strategies may be a stock- or portfolio-centric approach that additionally attempts to adapt volatility reduction to prevailing risk regimes. In low volatility environments, volatility reduction could be zero.

Performance Contours

While the framework we offer helps classify different approaches – active or passive – it’s imperative that you remain focused on outcomes. Because regardless of how we define them, defensive equity investing is a captivating investment thesis. The evidence is both persistent and global (Figure 2). A partial allocation to defensive equity strategies offers meaningful potential to add resiliency to your portfolio.

 

Figure 2 - MSCI World Index vs. Hypothetical Global Low Volatility Portfolio (2000-2019)

 

Reduced_Drawdowns

 

Equity-Like Returns Lower Risk

 

Two Use Cases

Defensive equity investing has a number of use cases, but few are clearer than those for defined benefit (DB) and defined contribution (DC) plans. DB plans continue to wrestle with funding gaps. DC plan participants actually face a similar dilemma. And regardless of equity market direction, both investors will continue to struggle with funding given low interest rates and increasing life expectancy.

Whether you’re paying out benefits from a DB plan or helping DC plan participants generate retirement income, implementing defensive equity strategies potentially improves funding status. And that may be especially true in flat or down equity markets (Figure 3).

 

Figure 3 - Potential Benefits to DB and DC plans

Discover More

The current market environment is driving many investors to take a hard look at defensive equity investing again. That’s why we’re offering a fresh look at the topic in our new eBook: An Institutional Investor Guide to Defensive Equity Investment.

A Guide to Defensive Equity Investing Add resiliency to your portfolio. Download eBook

 

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. 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.

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