bfinance: Defensive equity and market downturns

August 4, 2022

A new report from independent investment consultancy bfinance has provided fresh insight into the performance of defensive equity strategies. The report 'Defensive equity and market downturns: Is this time different?' identifies five distinct types of defensive equity strategy, delivering protection in different ways and with very different results.

Defensive and diversifying strategies are under scrutiny in 2022, with the MSCI ACWI losing 20% of its value in the first half in a climate of geopolitical upheaval and soaring inflation. 'Defensive equity strategies and market downturns' presents five types of ‘defensive’ equity strategy, explores their exposures and considers their performance.

Through historic market downturns, defensive long-only equity strategies have shown a consistent ability to protect investor capital. However, more recent experiences have prompted questions around their resilience.

Using proprietary active manager composites, bfinance estimates that the typical global equity Income strategy has outperformed the MSCI ACWI by approximately 11% in the first half of 2022 – saving investors from virtually half of the index’s losses – and Low Volatility strategies have beaten the benchmark by 8%.

However, Classic Quality strategies (which are often favoured by investors for their perceived defensive profile) have lost more than the market and Quality Growth strategies have underperformed by more than 8%.

Defining ‘defensive’ equity strategies

In order to provide clarity, the new report presents a new five-part classification framework for ‘defensive’ long-only equity strategies. The five types are: Low Volatility, Income, Classic Quality, Quality Value and (the least defensive) Quality Growth. As shown by the data in the report, these categories are very distinct from one other: investors may therefore wish to consider the use of multiple types within portfolio design.

‘Low Volatility’ strategies, at the most defensive end of the spectrum, seek explicit risk reduction. ‘Income’ strategies target companies with high dividend yields. ‘Quality’ strategies favour companies with characteristics such as a clear competitive advantage and a strong balance sheet, with ‘Quality Value’ strategies seeking undervalued Quality stocks on an opportunistic basis and ‘Quality Growth’ strategies looking at Growth characteristics alongside Quality.

There has been rapid growth within the Quality segment, with a particularly high volume of new fund launches targeting ‘Quality Growth’. Newer Quality Growth strategies tend to be more growth-oriented than the old guard of managers that used this label.

How have defensive equity strategies performed?

While ‘defensive’ strategies have proven their resilience during downturns, recent market declines have brought disappointment in some areas. Prior to the onset of COVID-19, managers across all five strategy types had (on average) delivered protection during periods of significant market decline.

Yet recent downturns – Q1 2020 (pandemic lockdown) and H1 2022 (war, rampant inflation and rate hikes) – have brought more mixed results. These exceptions, discussed in detail in the report, serve as an important reminder that every crash has its own unique drivers.

Several of these strategies are sacrificing considerable upside in exchange for their downside resilience. Low Volatility managers, in particular, have captured less than 70% of rising equity market movements over the past five years. The question of whether to sacrifice upside potential to gain downside resilience is a perpetual and controversial one. Investors should be sceptical of any strategy claiming to offer strong downside capture without an upside sacrifice.

Defensive strategies of various forms are expected to hold up relatively well under inflationary conditions. However, the outcomes will depend on whether central banks are able to engineer a ‘soft landing’ (higher interest rates without economic decline).

Looking inside ‘defensive’ portfolios

Investors should be aware of various biases that are contributing towards or detracting from returns. Defensive equity strategies range from highly Value-oriented (Low Vol, Income) to those without any Value bias (Quality, Quality Growth). Low Volatility managers have a structural bias towards Japan, while Income strategies favour Developed Europe.

Additionally, there are massive differences in average portfolio carbon intensity, with the Value-oriented strategies at a carbon premium and Quality strategies at a large discount.

The types of sectors associated with ‘Quality’ investing have changed dramatically over time due to deep structural changes in economies and markets. The onset of COVID brought this point to the fore: few observers would, previously, have considered IT companies as the ‘go to’ sector for defensive characteristics in a market downturn. Successful portfolio managers have anticipated and navigated these shifts.

Robert Doyle, Senior Director – Public Markets at bfinance, said: 'Capital preservation is very important for many institutional investors, and their equity portfolios will typically include one or more ‘defensive’ components to protect against market downturns. However, active managers across the different types of defensive strategy – Quality, Low Volatility and Income – allocate capital with very different mindsets and, by extension, end up with portfolios that have very different underlying exposures.'

And Doyle ads: 'Through this research, we were wondering if it is reasonable to expect each of them to be defensive in all downturns. Should asset owners think differently about which type of defensive strategy is right for them? And, with several strategy types having blemished their stellar track record of protection with disappointing performance in H1 2022, is 'this time' different?'