Swedroe: What Drives Defensive Strategies?

October 22, 2014

Novy-Marx’s work demonstrates that the anomaly found in the poor returns to small growth stocks is driven by unprofitable stocks that tend to have negative book equity. The success of defensive strategies in small stocks is a result of avoiding these high-risk stocks, not because of the low-volatility strategy itself. In other words, accounting for size, relative valuations and profitability, the performance of defensive strategies is thoroughly explained.

As an example, Novy-Marx found that a low-volatility, long/short strategy has a large value tilt with an HmL (high minus low) loading of 0.42 and an enormous large-cap tilt with a SmB (small minus large) loading of -1.12, in addition to showing a highly significant three-factor alpha of 68 basis points per month. However, 57 of the 68 basis points are from the short side, and expenses are not considered. Only 11 of the basis points are from the actual defensive stocks.

A Better Idea

You should also keep in mind that the popularity of defensive strategies has changed their very nature. Cash inflows have raised the valuations of defensive (low-volatility/low-beta) stocks, reducing their exposure to the value premium and lowering expected returns.

The bottom line is that the evidence suggests you would be better served either by screening out these high-risk stocks or investing in vehicles that do so. Consider investing directly in size, value and profitability, rather than in the indirect way associated with defensive strategies. One substantial benefit is lower turnover.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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