Last year’s economic turmoil culminated in many major equity markets entering bear market territory. It was no different for bonds, with the annual returns of most indices in the red. However, this scenario helped defensive equity sectors and assets outperform.
But as equity markets are now in positive territory, with some reaching record highs, is the defensive approach that prevailed last year still the right choice for investors?
Traditionally, institutional investors (such as pension funds and insurers) wishing to construct a defensive portfolio would simply buy more government bonds and sell off some of the equities they owned. Now that most of the global rate hikes are behind us, this seems like an attractive proposition. However, even if fixed-income yields offer substantially better returns than two years ago, the expectations from investors – institutional and retail alike – are also higher on the back of very high inflation and the rising cost of living. This means that a larger allocation to fixed income is rarely enough to attract or retain end investors.
In this scenario, investors willing to extract further yield from equities typically have two options: either increase allocation to stocks with more defensive characteristics or overlay a defensive component by purchasing options. They may also consider adding other securities such as commodities to the asset mix. But what if you could combine all these sources of return within transparent investment strategies that aim to optimise the return on allocated capital?
The role of defensive equities
Certain stocks may have a defensive profile or operate in defensive sectors – such as consumer staples, health care and utilities – that are traditionally expected to be more resilient during recessions. These have a role to play within defensive portfolios, but there are limitations: not only can portfolios become concentrated if they are too exposed to certain sectors, but their performance can be affected by macro factors.
This is a real threat today, in times of high inflation, as some of the sectors mentioned above (utilities, consumer staples) tend to suffer. Instead, stocks that have a ‘value’ tilt tend to fare better, but they are often found in sectors such as financials, energy and materials, which are more pro-cyclical and clearly not ‘defensive’ in the face of recessions.
Systematic innovation for defensive equity portfolios
This calls for another approach to portfolio diversification – one that doesn’t exacerbate risks or costs, where the equity investment process can be built to transform a pure directional risk into a yield-orientated investment. This can be achieved by using options as a defensive overlay.
For example, a core diversified portfolio of stock selection based on fundamentals can be complemented by selling short-dated call options and buying long-dated put options: whilst the calls aim to enhance yield and mitigate volatility, the puts aim to improve the strategy’s risk/return ratio relative to a direct investment in the stocks.
One such strategy is implemented in the THEAM Quant Sicav, through the Equity iESG Eurozone Income Defensive sub-fund. It focuses on picking quality dividend stocks with good environmental, social and governance (ESG) credentials, and its overlay mechanism has been reinforced over the years to better navigate patterns of sharp drawdowns and rebounds. The long-term simulated performance of its underlying strategy displays an average volatility around 13.7% since 2008, where a comparative EURO STOXX Net Return Index experienced volatility averaging 21.5%.
Going beyond equities
However, if the quest is for returns in excess of fixed income without the drawdown risk of equities, then venturing beyond equities should be a fitting way to construct a more robust portfolio in a cost-effective manner for all climates. For example, futures-based markets like commodities or volatility may offer very diversified and complementary sources of income.
Commodity carry strategies are well documented to potentially offer such ‘defensive carry’ – a ‘Grail-like’ combination of average long-term positive returns and strong absolute or relative performance during equity drawdowns or recessions. On their own in a portfolio, they can help, but combined with other uncorrelated strategies, they can really shift a portfolio into another gear.
Long-term wealth preservation
With investors keen to increase risk-adjusted returns and deliver long-term returns akin to traditional benchmarks during periods of financial distress, defensive portfolio overlays have been gaining popularity. Done well, the most robust of these strategies should be aiming to deliver long-term returns not too far from traditional benchmarks but at a significant reduction in portfolio volatility.
Some markets may be rising, but overall, it is a mixed global picture. The market remains unpredictable. For those focused on long-term preservation, without the tolerance for periods of big drawdowns, some allocation to defensive equity strategies, or a defensive overlay to the core portfolio, should make sense, whether this is within equities, or beyond.
Vincent Berard is head of BNP Paribas Global Markets THEAM Quant funds’ Product Strategy. The views expressed above should not be taken as investment advice.