Understanding Defensive Stocks and Their Trade-offs

Russ Koesterich, Global Chief Investment Strategist

Daniel Morillo, Global Head of Research and Co-Head of Model Portfolio Solutions

A combination of market volatility, economic weakness and political uncertainty has led many investors to favor equities perceived to be defensive in nature. While many of these stocks have posted solid performance since the 2008 crash, more recently much of this space has struggled, calling into question the effectiveness of going “defensive” as an investment strategy.

A defensive strategy will be most effective if investors are clear as to the risk they are trying to mitigate. While defensive typically refers to stocks that have a beta less than one—in other words, they are less sensitive to market risk—the definition often leaks into other concepts, such as whether or not the company’s business model is robust to a slowing economy. Specifying the particular risk—market, economic, rates—is important, as not all defensive names perform the same under varying conditions.

Investors also need to adjust their thinking over time. What constitutes a defensive name changes as business models and market conditions evolve. At the time of the market’s peak in 2000, technology stocks had a beta nearly twice that of the market. Today, the technology sector’s volatility is broadly in line with the overall market, while financial companies have become more volatile, something that may change again if financial regulation creates a more boring, less volatile business model.

Finally, and perhaps most importantly, investors must consider the cost of overweighting defensive stocks. Most defensive bets, while mitigating one risk, will expose portfolios to a different one. For example, protecting a portfolio against inflation normally comes at the cost of increasing the overall volatility through higher equity exposure. In addition, and particularly in the current environment, investors need to avoid overpaying for what are perceived to be defensive names, something we see today, specifically in the utilities sector.

     

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