Traditionally, risk-averse investors seeking defensive equity strategies have focused on low-volatility or low-beta assets. However, the objectives of defensive investors may go beyond volatility reduction to include long-term capital preservation, economic exposure diversification, and drawdown reduction. Given those considerations, a minimum-variance approach may not be the optimal portfolio.
Ross French and Niklas Gärtner contribute to the literature with their study, “In Search of a Defensive Equity Factor,” published in the April 2023 issue of The Journal of Portfolio Management, in which they sought to establish which equity factors are appropriate for defensive investors. They defined defensiveness along three dimensions:
- Low risk of permanent capital loss – defined as a total return of -30% or less between each respective analysis date and the period ending December 31, 2021. In addition, to ensure that the stock characteristics at the time of analysis were relevant to the stock’s subsequent loss, they also required that the total return over the year following the analysis date was negative.
- Low market risk – should have comparatively low variance, be less negatively skewed than the market, and avoid extreme returns.
They analyzed low volatility as well as six characteristics that have been highlighted in the literature or by investment practitioners as representing quality:
- Low volatility, measured three ways: price volatility, measured using weekly returns over the previous five years; earnings volatility, measured using the volatility of earnings over the previous five years normalized by their average level over the same period; and profitability volatility, measured using the volatility of return on assets (ROA) over the previous five years normalized by its average level over the same period.
- Asset turnover: sales over assets.
- Earnings quality, measured by the level of accruals.
- Growth: forward-looking growth rates based on the median two-year forward earnings per share forecast from the Institutional Brokers’ Estimate System.
- Investment, measured six ways: abnormal capital investment, growth rate of capital expenditures, total asset and book equity growth, external financing growth, and share issuance growth.
- Leverage, measured five ways: total assets to book equity, total debt to total assets, total debt to book equity, net debt to book equity, and cash flow from operations to debt.
- Profitability: measured as return on equity, return on assets, gross profitability over assets, cash earnings over assets, cash flow from operations over assets, net profit margin, and return on invested capital.
Their data sample included constituents of the FTSE developed and emerging indexes and covered the period September 2000-December 2021. They defined four business cycle stages:
- Slowdown (27% of the period): non-recessionary below-trend growth.
- Recession (13% of the period): two consecutive quarters of negative growth.
- Recovery (25% of the period): post-recessionary (24 months) above-trend growth.
- Growth (35% of the period): remaining months (after the first 24) of above-trend growth.
Following is a summary of their key findings:
- Low leverage, earnings volatility, and return volatility were the most consistently defensive.
- Profitability was the next most powerful characteristic, but for it to be reliably defensive, leverage must have been controlled in its definition or implementation.
- The case for quality was less clear and depended on how quality was defined. For example, asset turnover and earnings quality, measured by the level of accruals, behaved like defensive characteristics, though to a lesser extent and less consistently.
- Profitability measures using assets in the denominator, in particular the gross profitability metric, were more defensive, while those using book value were less defensive because they risked capturing stocks with high leverage.
- Low investment had lackluster results in all tests.
- High forecast growth was entirely inappropriate for defensive investors.
- Historical volatility was a highly informative metric when assessing the probability of future permanent drawdowns: “The oft-made risk distinction between temporary price volatility and permanent capital losses is slightly overdone.”
- During business cycle recessions and slowdowns, the leverage, volatility, volatility of earnings, and gross profitability metrics performed best, producing positive returns. Because the performance of the other characteristics varied by definition, they cautioned against drawing conclusions.
- All the earnings quality, leverage, low-volatility, and profitability portfolios had positive up/down capture ratios, and all the portfolios except the growth, investment, and asset turnover portfolios had down capture ratios below 1.
- The results were broadly the same in emerging markets.
French and Gärtner also found: “Despite their associated risk reduction, defensive characteristics actually generate significant positive excess returns.” Explanations for this anomaly are the “lottery effect” (the willingness to accept poor odds for a chance to win a huge return) and limits to arbitrage (caused by the risks and costs of shorting) that prevent sophisticated investors from correcting mispricings.
Summarizing their findings, French and Gärtner stated: “Three of our characteristics – earnings quality, leverage, and low volatility – have a clear and direct theoretical connection to our defensive portfolio attributes. Asset turnover, investment, and profitability may also have valid economic rationale for being associated with our attributes, though it is dependent on how they are defined and/or how they impact capital structure. Theoretically, growth is a risk factor and is not defensive.”
Investor takeaway
French and Gärtner demonstrated that risk-averse investors seeking defensive systematic strategies to reduce left-tail risk should broaden their search beyond low volatility/low beta to include exposure to companies with not only low volatility but also low leverage, low earnings volatility, and high gross profitability.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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Traditionally, risk-averse investors seeking defensive equity strategies have focused on low-volatility or low-beta assets. However, the objectives of defensive investors may go beyond volatility reduction to include long-term capital preservation, economic exposure diversification, and drawdown reduction. Given those considerations, a minimum-variance approach may not be the optimal portfolio.
