Over a 40-year working life, defined contribution (DC) plan savers try to maximize two basic investment outcomes: wealth accumulation and wealth preservation. However, these objectives present a basic tradeoff: for many retirement savers, the investments designed to promote wealth accumulation (equities) are different from the investments designed to promote wealth preservation (e.g., cash, bonds). Defensive equities seek to provide a “best of both worlds”: delivering the equity risk premium to achieve wealth accumulation, but by investing in less-risky equity securities to promote wealth preservation.
The Defensive Premium
One of the oldest findings in finance is that lower-risk stocks deliver returns that are “too high” compared to what traditional models predict.2 As shown in Figure 1, over the long term, lower-risk U.S. stocks (left side) have delivered approximately the same average return as higher-risk stocks (right side). Defensive equity3 strategies seek to capture this premium by investing across a range of low-risk stocks, with the objective of achieving market-like returns but with less volatility.4
What Drives the Defensive Premium?
Various theories seek to explain why defensive stocks perform as well as they do. One of the oldest and most tested is “leverage aversion,” which considers what happens to stock prices when a meaningful subset of investors are unable or unwilling to use leverage.
In general, equity investors with aggressive return targets have two options: 1) invest in higher-risk stocks in hopes of being rewarded with commensurately higher returns, or 2) use leverage to magnify the return on lower-risk stocks. However, in a leverage-averse world, investors do not have a choice between options 1 and 2. Instead, they are forced to take option 1: invest in higher-risk stocks.
The resulting high demand for higher- risk stocks means their prices get bid up and their expected returns go down. The opposite holds for lower-risk, or defensive, stocks: Because there is less demand for them, their prices are bid lower and thus may be expected to perform better than they otherwise would.
What Makes a Stock “Defensive”?
There are many ways to evaluate whether a security is defensive. These fall into two categories: fundamental and quantitative. From a fundamental perspective, companies with low risk may have relatively high margins, sustainable earnings and low credit risk.5 From a quantitative standpoint, companies with low risk may be those with low beta, or sensitivity to the market, or low volatility. We believe both categories are useful for identifying defensive companies and that the combination is likely to produce a more robust portfolio of truly defensive stocks.
Defensive and Defined Contribution
Defensive equities may be among the best suited to meet the twin objectives of wealth accumulation and wealth preservation. Figure 2 charts the rolling threeyear average returns of two portfolios: a hypothetical U.S. large-cap defensive equity strategy and the Russell 1000. In good times the returns are comparable,which supports the idea that defensive equities may achieve returns on par with passive equities and thus provide a similar engine for growth.
The difference, though, can be seen in the shaded areas in Figure 2 — periods when lower volatility led to smaller drawdowns, demonstrating that defensive equities may be better at achieving wealth preservation in down markets.6 This characteristic is clearly valuable near retirement, when investors have less time to ride through a market drawdown. But it may also aid younger savers, who may be less likely to throw in the towel after a severe — and potentially prolonged — bear market, maintaining the allocations they need to accumulate enough savings for retirement.
1 For more, see Frazzini, Friedman and Kim (2012), “Understanding Defensive Equity.”
2 Early studies include Black (1972).
3 Defensive Equity, Low Beta, Minimum Variance, Low Volatility — these names all describe investment strategies that generally seek to overweight safe securities and underweight risky securities (relative to capitalizationweighted benchmarks).
4 Evidence for the defensive premium is pervasive. Beyond the U.S., we find decades of evidence in international markets and in other asset classes—such as bonds and credit—that point to the same basic conclusion: Defensive strategies may generate returns similar to those of overall markets but with less volatility (and thus generally smaller drawdowns).
5 Consistent with the earlier evidence, safe, profitable and stable companies have historically earned higher riskadjusted returns than risky, unprofitable and unstable firms, as shown in Piotroski (2002), Novy-Marx (2012), Asness, Frazzini and Pedersen (2012).
6 Over the full period show in Figure 2, the average volatility and total return of the Russell 1000 are 15% and 11%, respectively. For the Hypothetical Defensive Strategy the average volatility and total return are 12% and 12%, respectively.
Asness, A., Frazzini, A., Pedersen, L.H. (2012), “Quality Minus Junk,” Working Paper.
Black, F. (1972), “Capital Market Equilibrium with Restricted Borrowing,” The Journal of Business, Vol. 45, No. 3, pp. 444-455.
Frazzini, A., Friedman, J., Kim, H. (2012), “Understanding Defensive Equity,” AQR White Paper.
Novy-Marx, Robert (2013), “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics 108(1), 2013, 1-28. Piotroski, Joseph D. (2000), “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers,” Journal of Accounting Research, 38, 1-41.
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Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. The Russell 1000 Index is a stock market index that represents the highest-ranking 1,000 stocks in the Russell 3000 Index, which represents about 90% of the total market capitalization of that index.
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