In Defense of Defensive Equity Investing

This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.

Defensive equity funds--those that try to protect on the downside--have been popular during the past several years. According to Morningstar's Alex Bryan, there are more than 140 defensive equity funds listed in the U.S., with $74 billion in assets.

Defensive funds can come in several flavors, ranging from active managers investing in traditionally defensive stocks with low fundamental risk to passive strategies focusing on low-volatility stocks.

At the 2018 Morningstar Investment Conference, Bryan explored the topic of defensive equity investing with Fidelity's Darby Nielson, MSCI's Raman Subramanian, and Invesco's Meggan Walsh. They covered why these strategies are attractive to investors today, what investors should (and shouldn't) expect from these investments, and whether defensive stocks are overpriced today.

Nielson noted that you can define defensive equity investments a couple of different ways--and depending upon your definition, there are different reasons for the popularity.

"If you define it as dividend stocks, they've been popular because interest rates have been so low," he explained. "For low-volatility stocks, there could be two reasons. First, low-vol strategies can enhance return. And if you add low volatility strategies to a portfolio, you can lower risk."

Walsh doesn't expressly invest in low-vol stocks; rather, she focuses on dividend stocks with low fundamental risks, arguing that the market rewards these stocks over time for their strong balance sheets and cash flows.

"The variability of their earnings over time, too, which is appreciated in a down market," she added.

"Low vol strategies capture market beta with lower risk," said Subramanian. In a nutshell, they win by not losing as much. Low vol comes in a variety of forms, he continued. The most transparent strategy involves ranking stocks by volatility and homing in on those stocks with the lowest volatility. Other strategies, meanwhile, use optimization processes and are therefore less transparent--but they can eliminate unintended sector biases.

The panelists were split on what impact rising rates will have on defensive strategies.

"Low vol tends to underperform when rates rise," said Nielson. "When rates are going up, it's because bond prices are going down. And that means it's usually a risk-on environment, which poses a challenge for low vol strategies."

Subramanian, meanwhile, noted that the downside protection of low vol strategies doesn't change if interest rates are rising.

Bryan asked the panelists to provide investors who are thinking of getting more defensive with some advice.

Nielson recommended that investors thoroughly vet the strategies, understanding the way the defensive portfolio is constructed and what unintended sector exposures there might be.

"These strategies are very different," he noted.

Walsh, meanwhile, suggests that investors look for consistent processes, and evaluate strategies from peak to peak and trough to trough.

"Understand when the strategy will underperform," she said. No strategy outperforms all of the time.

Lastly, Subramanian reminded investors that valuations have increased for low vol stocks, but that doesn't mean that they've lost their low-vol qualities. He did, however, caution investors to remember that low vol funds aren't bond substitutes.

"Even though these should be lower risk, these are still equity products."