A recent paper explores the outperformance of defensive equity approaches.
The two severe bear markets we experienced in the first decade of the 21st century led many investors to seek the safety of defensive equity strategies. A defensive equity strategy focuses on employing stocks that have a lesser degree of downside—and upside—volatility than the overall market.
The explosive growth in demand for defensive equity has been fueled by the publication of papers demonstrating that, historically, low-volatility/low-beta strategies have provided similar returns to the market while experiencing less overall volatility and, specifically, less downside risk.
The result has been a flood of capital into a broad category of strategies we can term “defensive equity.” This category now includes not only low-beta and low-volatility strategies, but also equities that generally have been referred to as quality stocks.
According to traditional financial theory, the superior risk-adjusted performance of these defensive strategies represents an anomaly because there are no good risk-based explanations. However, limits to arbitrage and the fear of margin, as well as the risks and costs of shorting, can allow behavioral anomalies to persist.
That said, investors should consider whether the superior returns to defensive strategies will persist now that the “cat is out of the bag.” The publication of research identifying anomalies will often lead to their elimination. On the other hand, the momentum premium has long been known. It is a result of behavior, not risk, and yet it persists across markets and asset classes.
Robert Novy-Marx took a look at the issue of defensive equities in his September 2014 paper, “Understanding Defensive Equity.” His study covered the period 1968-2013. Following is a summary of his conclusions:
- High-volatility and high-beta stocks tilt strongly to small, unprofitable and growth firms. These tilts explain the poor absolute performance of the most aggressive stocks, which are often referred to as “jackpots” or “lottery tickets.” These stocks make up a very small percentage of the total market capitalization.
- Ranking stocks by quintiles, either by volatility or beta, shows that while the highest quintile stocks dramatically underperform, performance of the other four quintiles is very similar and market-like.
- The underperformance of these high-risk (small, unprofitable and growth) stocks drives the abnormal performance of defensive equity.
- Profitability, using various measures, is a significant negative predictor of volatility.
- Defensive strategy performance is well explained by controlling for the common factors of size, profitability and relative valuations.
- Higher levels of leverage are significantly related to volatility. However, there’s no significant role played by leverage after accounting for size, valuations and profitability.
- Defensive strategies tilt strongly toward large stocks and profitable stocks. For example, low-volatility stocks are, on average, more than 25 times as large as the high-volatility stocks at the end of the sample. The profitability tilt obscures the extent to which defensive strategies tilt toward value. Because value and profitability tend to be strongly negatively correlated, unless a comparison controls for profitability, the value loadings of defensive strategies will be lowered.