Swedroe: What Drives Defensive Strategies?

October 22, 2014

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.

Novy-Marx’s Findings

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.


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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