While defensive equity strategies have provided protection during previous downturns, this year’s results have been disappointing in some cases. In particular, strategies with a quality growth style have done considerably worse than the market.
This is according to bfinance’s research into the performance of defensive equity strategies during eight market downturns, including the one from January to June this year. Bfinance is an independent, privately-owned investment consulting firm that provides advice and solutions to pension funds and other institutional investors around the globe.
“Quality Growth strategies are not as defensive as their marketing often suggests,” the researchers concluded. “As a group, they have higher volatility than the benchmark and a downside of more than 90 per cent. This indicates relatively little protection against market declines.”
8 percent worse
Despite their preference for companies with good results, a competitive edge and a reasonable valuation, quality growth strategies have performed 8 percent worse than the MSCI ACWI in the first six months of this year.
Bfinance argued that the sectors categorised as ‘quality investments’ have changed dramatically over time due to profound structural changes in economies and markets. “The onset of the Covid pandemic has brought this point to the fore,” the research firm said.
The IT sector is an example of an industry that few market participants used to see as having defensive characteristics. On average, investors with a quality growth style are mostly large in IT and health care and small in energy, materials and financials, relative to MSCI.
Another reason for the underperformance of quality growth funds bfinance attributed to the huge influx of new funds within this style. Newer Quality Growth strategies tend to be more growth oriented than the old guard of managers who used this label.
Other defensive strategies
Of the other four defensive styles identified by the consultancy, income strategies, low volatility strategies and quality value did best in the first half of this year. They outperformed the MSCI ACWI by 11%, 8% and just under 8% respectively, which finished at around -20% at the end of June.
Classic quality, on the other hand, underperformed the market by 1%. According to bfinance, this is mainly because many managers with this style do not invest in companies that were on the rise in the first half of the year: cyclical value stocks in sectors such as energy, materials and utilities.
In terms of drill-downs, bfinance’s research shows that the five different types of defensive strategies held up well during market declines between 2008 and 2016, but the first cracks have appeared since then. During the market downturn in autumn 2018, quality growth performed slightly worse than the benchmark; in spring 2020, income lost ground against the benchmark. And during this year’s market decline, two styles underperformed. “An important reminder that each crash has its own unique characteristics,” the firm said.
Perennially controversial question
The fact that some other defensive styles held up relatively well in the first half of the year also puts bfinance directly into perspective. After all, it does not at all make up for the losses of these strategies in previous years.
Low-volatility managers in particular have captured less than 70% of the rising market movements in equities over the past five years. The question of whether upside potential should be sacrificed at the expense of downside resilience is a perennial and controversial one. Investors should be sceptical of any strategy that claims to offer strong downside protection without upside sacrifice.
Institutional investors in particular, who tend to add more defensive components to their portfolios due to their emphasis on capital preservation, should take another critical look at their allocation to defensive strategies, said bfinance’s senior director Robert Doyle .
“Active managers of the different types of defensive strategies - quality, low volatility and income - deploy their capital in very different ways,” said Doyle. “As a result, their portfolios have very different underlying exposures. This research makes us wonder: is it reasonable to expect all of them to be defensive in all recessions? Should asset owners be thinking differently about what type of defensive strategy is right for them?”
What the future holds
While defensive strategies tend to hold up relatively well in inflationary conditions, the performance of such funds in the period ahead will depend on whether central banks are able to deliver a ‘soft landing’.
On quality growth strategies in particular, director of public markets Martha Brindle said they tend to have strong pricing power and an established client base, which allows them to pass on price increases to end-users. “However, they are also often valued on the basis of high expected future cash flows, which makes them vulnerable if future growth expectations soften. That vulnerability can be exacerbated by rising interest rates, which increase the discount rate that many investors use to calculate estimated future values back to the present.”
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