When markets are rising, investors don’t always prepare for turbulence. Yet we think the best time to build a defensive plan for an equity allocation is before volatility strikes.
Investors who seek defensive equity portfolios might think they need to sacrifice long-term return potential to reduce volatility. However, they may be surprised to discover how a strategy targeting stocks that lose less in a downturn can in fact beat the market over time.
Most investors implicitly understand the concept of risk. The framework was famously laid out in the capital asset pricing model (CAPM) of the 1960s, which explained expected return as a function of both firm-specific risk and an asset’s sensitivity to the broader market. Fundamentally, however, it’s grounded in a simple concept: investors expect to be compensated for assuming more risk. If risk had no payoff, we’d all just keep our assets in cash and call it a day.
Relative vs. Absolute Risk in a Choppy Market
Too often, investment managers are consumed with relative risk—tracking their performance against a market-cap-weighted benchmark index. This can conflict with what really matters to investors: absolute performance and how well an investment addresses long-term financial goals.
The issue becomes especially thorny during bouts of market volatility, such as the 2022 downturn. Amid stubborn inflation and economic slowing last year, the S&P 500 retreated by 18.1%. While stocks have recovered sharply in 2023, the potential for more volatility is a clear and present danger amid macroeconomic uncertainty and ongoing concern about inflation and high interest rates.
When markets are rising, investors don’t always prepare for turbulence. Yet we think the best time to build a defensive plan for an equity allocation is before volatility strikes.
Is It Possible to Realize Higher Returns with Less Volatility?
What if there were a way to generate long-term competitive returns without the need to endure extreme swings in volatility?
This would seem to contradict CAPM and the other maxims related to risk and return. But a growing body of research indicates that, with a carefully curated portfolio, investors can indeed assume less risk and still beat the market over time by investing in low-volatility stocks. By doing so, investors can gain confidence to stay invested in equities through turbulent times.
Low-volatility strategies can come in different forms. We believe that an effective defensive strategy should be grounded in company fundamentals and focus on firms that exhibit characteristics of quality (consistent cash flows and measures of profitability like return on invested capital), stability (low volatility of returns relative to the market) and attractive pricing that make them less susceptible to wide market swings. We refer to this as the QSP universe. While companies in traditionally defensive sectors like consumer staples and utilities are good examples, the QSP universe includes firms with standout business models in every sector of the economy, which can be uncovered through fundamental research and thoughtful stock selection.
For example, companies that we call quality compounders have successful business models and sustainable earnings, backed by good capital stewardship and positive ESG behavior. Intangible assets such as brands, culture, research and development, and patents are also valuable features, particularly in times of stress. These attributes support compounding earnings gains from consistent growth drivers through market cycles.
Limiting the Ups and Downs Is Key
Companies like these can help low-volatility strategies limit downside capture—that is to say, exposure to falling markets—while still participating in market gains, but not fully. In the same way that climbing a hill is easier when you start halfway up, stocks that lose less in market downturns have less ground to regain when the market recovers. As a result, they’re better positioned to compound off those higher returns during subsequent rallies, resulting in better long-term performance.
This concept can be illustrated by plotting a so-called 90%/70% portfolio of US stocks against the S&P 500 Index (Display). This theoretical 90%/70% portfolio is so named because it would capture 90% of the market’s gains in rallies while falling only 70% as much as the market during downturns.
Using data from January 1, 2000, through July 31, 2023, we found that our hypothetical 90%/70% portfolio would generate annual returns 3.2% higher than the S&P 500 Index over this period—with less volatility in the process (Display).
