Using defensive equities in a return-seeking portfolio: A factor framework for corporate plans

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.

How can different defensive factors help and be added to a portfolio?

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:

• Low volatility factors may be accessed via quantitative low volatility and minimum variance strategies;
• Cash compounder factors may be accessed through quality and dividend-growth strategies; and 
• Income-oriented factors may be accessed via equity income and defensive or quality-value strategies. 

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.

How defensive factors have performed over time

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).

Figure 1

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:

• The upside capture of the US profit stability factor stands out at about 90% (left-hand chart).
• The low volatility factor captured only about half of the downside over the 20-year period (right-hand chart). 
• The US sustainable income factor fell in the middle of the three strategies in terms of both upside and downside capture. However, from a defensive standpoint, we think it can potentially play two additional complementary roles unrelated to the return behavior. First, it may function as a current-income lever that can be adjusted up or down depending on a plan’s cash needs. Second, it may provide valuation sensitivity (yield is a valuation multiple). While low volatility and cash compounder factors typically trade at a premium to the market, there can be significant multiple compression in those factors in the early phase of the market cycle. In that case, sustainable income may act as a diversifier and potentially mitigate some of that valuation risk.

Figure 2

The current environment for factors

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:

• As is typical, the US sustainable income factor traded at a discount to the market (1.00), highlighting the potentially unique role it can play in providing valuation sensitivity, as mentioned earlier.
• The fourth quarter 2023 valuations of all three factors were below the historical median. Low volatility and US profit stability were trading not just at a discount to their long-run valuation, but also to the market (i.e., they were below 1.00).

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.

Figure 3

Figure 4

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):

• Index completion overlay sleeves can be added to multi-sleeve solutions. This involves directly allocating to the larger names in a particular benchmark (e.g., the mega-cap technology stocks) and sizing that allocation to essentially reweight those names and allow the active positioning of the manager to shine through.
• In direct factor-investing strategies, where a manager owns the entire portfolio construction process, the names can potentially be added to the “buy list,” allowing them to be purchased as risk positions, which may help hedge this dynamic.
• Finally, in the core equity space, extension (140/40) strategies may have an advantage. They can potentially empower the risk takers to “reshape the benchmark” by using additional capital generated from high-conviction shorts to neutralize the impact of the large index weights.

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.

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