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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Return-seeking portfolio construction is an important consideration for corporate defined benefit (DB) plans at all stages of their glidepath. Within the return-seeking portfolio, we believe that balancing upside equity participation with funded-ratio drawdown mitigation is key to long-term success. As discussed in a previous paper, we think plans working to balance these objectives should consider three return-seeking building blocks. The first two are core equities and diversifying strategies (e.g., liquid infrastructure, return-seeking fixed income, REITS/real estate, low-beta hedge funds). The third is defensive equity strategies, which we define as approaches with a philosophy and process explicitly aligned with downside mitigation, creating the potential for downside capture below 100% while maintaining meaningful upside capture. Pairing core equities with defensive equities and diversifying strategies may create another lever to reduce funded-ratio volatility, in addition to other derisking steps (e.g., adding to long-duration fixed income).
We are often asked by plan sponsors how we identify strategies that fit the defensive equity category, and at the heart of that process is the work of our Fundamental Factor Team. Here we discuss the team’s views on defensive factors, including their role and options for accessing them, their historical performance, and the current factor environment.
While many allocators think solely of low volatility strategies when they hear the term “defensive factors,” we see three categories that can potentially play distinct and complementary roles:
Low-volatility factors may serve as the downside mitigation “anchor” for a defensive strategy. In the data we share in this article, they are represented by our US low volatility factor, which is based on the bottom decile of the US market by forecast volatility generated from a US risk model (in this and the other categories below, these factor buckets are cap weighted and rebalanced monthly).
Cash-compounder factors may contribute to better upside participation relative to other defensive factors. They are represented by our US profit stability factor, which is the top decile of the US market when sorted by the stability of economic profits generated over the past 10 years.
Income-oriented factors may provide current income and valuation sensitivity that is often lacking in purely defensive strategies, given that defensive stocks tend to trade at a premium to the market. They are represented by our US sustainable income factor, which is the top decile of the market when sorted by a composite factor score based on a stock’s dividend yield, dividend stability, sustainable growth, and solvency risk.
Active manager strategies offer one option for tapping into these factors. For example:
The three factors could also be incorporated in a portfolio using a multi-strategy solution that can adjust the strategic weights in pursuit of specific levels of upside/downside or current income. Finally, another option is a multi-factor solution that can allocate to all three factors in a holistic approach, allowing the factor weights to be adjusted to target particular objectives — similar to the multi-strategy approach.
To bring these factors to life, Figure 1 compares their returns to the broad US market over two time periods. Over the past 20 years (dark-blue bars), the US profit stability factor and the US sustainable income factor beat the market. The low volatility factor performed in line with the market but with much lower volatility.1
Turning to the past 10 years (light-blue bars), we would first note that this is a period in which market leadership in the US was very narrow, at both the style level (growth over quality and value stocks) and the stock level (dominated by a handful of technology and technology-adjacent companies). Against this backdrop, we see that among the defensive factors, only the US profit stability factor outperformed the market (more on this market narrowness issue later in the article).
Next, we take a closer look at the behavior of the factor returns over time, in Figure 2. On the right side of the chart, we find that all three factors were “defensive” — that is, they all achieved a downside capture well below 100%. A few other observations on the data:
With that historical backdrop in mind, what does the current market environment for these defensive factors look like?
1. An attractive entry point?
Let’s start with valuations, highlighted on the left side of Figure 3. This chart shows the ratio of the weighted average price-to-book (P/B) ratio of the stocks in each factor group, relative to the weighted average P/B ratio of the broad US market. The dark-blue bars indicate where that ratio stood at the end of the fourth quarter of 2023, while the light-blue bars show the long-term median valuation.
A couple of observations on the data:
Turning to the chart on the right in Figure 3, we look at the relative “momentum exposure” of each factor — i.e., the active exposure to a momentum factor (in a Barra model). A result below -0.2 is considered significant. This metric may be helpful in that forward returns for defensive factors have tended to be better when they have a “contrarian” starting point (i.e., negative momentum exposure).
As the data indicates, the long-run tendency was for the low volatility and US profit stability factors to be neither momentum nor contrarian. The US sustainable income factor, not surprisingly, was more contrarian, meaning the price action of the past year tended to be more negative for stocks in that bucket than for the market.
As of the end of 2023, all three factors were significantly contrarian. That’s meaningful because when you look at 12-month forward returns for defensive factors, momentum has historically been a strong predictor of performance. Specifically, the returns for defensive factors tend to be better from points of very negative momentum rather than strong momentum. This makes sense given that often as the market tops, there is negative momentum for the factors and then they can potentially provide downside mitigation going forward.
All in all, we think this paints a picture of a potentially attractive valuation entry point and technical entry point for these factors.
2. Interest-rate sensitivity
One common concern we often hear about defensive factors is that they tend to be long duration and therefore may suffer in periods of rate increases. But we think the evolution of core equities has altered that relationship.
The top chart in Figure 4 shows the marginal excess return forecast generated by a macroeconomic model, assuming a one standard deviation rise in 10-year rates at any point in time. So, looking at the beginning of the chart for example, we see that 10 years ago the model forecast that given a one standard deviation rise in the 10-year rate, the low volatility factor would have been expected to underperform core equities by about 4%. However, the trend in the chart for all three factors has been from a fairly negative relationship in a rising-rate environment to an essentially neutral relationship. We were initially surprised by that trend and assumed it reflected a change in the composition of the factors. But instead, we found it was the core equity benchmark that had changed.
The bottom chart in Figure 4 captures the return forecast for the benchmark assuming the same one standard deviation rise in the 10-year rate. For most of the past decade, core equities had negative duration (i.e., a positive return forecast given a rising 10-year rate), but the return forecast has fallen since the pandemic to the point where the duration is roughly neutral — a significant change in a relatively short time.
What’s contributing to this dynamic? The answer appears to be a dramatic shift in the composition of the benchmark driven by the information technology and energy sectors. For example, over the past 10 years, the information technology sector’s weight in the MSCI USA Index has roughly doubled from about 14% to nearly 30%, while the energy sector’s weight has been roughly halved from about 10% to just under 5%.
Why does this matter? IT stocks tend to be fairly long duration given that they are often high-growth stocks, which means much of the value of the company is in the form of cash flows to be paid in the future. On the other hand, energy stocks tend to be very short to negative duration given that they tend to be low growth and much of the value of the company is generally in existing assets. The combination of these two changes in the index likely helps explain the steep drop-off in the equity market exposure to rising rates that we saw in Figure 4. In short, we think this suggests that the core equity index to which defensive factors are being compared has become less interest-rate sensitive, suggesting that defensive factors may be less likely to underperform in a rising-rate environment.
3. Market narrowness
The growth of the information technology sector noted above relates to another issue worth considering in the context of defensive investing: the increasing narrowness of the equity market. The reasons for and implications of market narrowness and the recent dominance of a handful of technology stocks (the Magnificent Seven) are a subject we could devote an entire article to, but from a factor standpoint, the upshot is that all three defensive factors have generally been underweight the largest benchmark names in recent history, and thus index concentration has been a notable headwind for their performance.
We see a number of possible solutions to this headwind for defensive strategies (solutions that may also apply to core equities as allocators evaluate broad equity portfolios and active manager exposures):
We would welcome the opportunity to discuss these ideas further — or any other aspect of our research on defensive factors and their potential role in an LDI framework.
1For the 10 years ended 30 September 2023, annualized volatility for the low-volatility, US profit-stability, and US sustainable-income factors was 12.46, 13.81, and 14.06, respectively. For the 20 years ended 30 September 2023, annualized volatility for the low-volatility, US profit-stability, and US sustainable-income factors was 11.42, 13.36, and 14.05, respectively. Sources: Wellington Management, FactSet. Past performance is not a guarantee of future results.
Important disclosure
MSCI data — Neither MSCI nor any other party involved in or related to compiling, computing, or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates, or any third party involved in or related to compiling, computing, or creating the data have any liability for any direct, indirect, special, punitive, consequential, or any other damages (including loss of profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’S express written consent.
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