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- Defensive equity strategies are comprised of stocks that lose less than the market during bear markets while keeping up with the market during a bull market.
- Coarse sorts on metrics such as volatility, beta, value, and momentum lead to diversified portfolios but have mixed results in terms of their defensive characteristics, especially through different crisis periods that may favor one metric over another.
- Using non-linear machine learning techniques is a desirable way to identify certain combinations of factors that lead to better defensive equity strategies over multiple periods.
- By applying techniques such as random forests and gradient boosting to two sample defensive equity metrics, we find that machine learning does not add significant value over a low volatility sort, given the features included in the model.
- While this by no means rules out the benefits of machine learning techniques, it shows how a blanket application of it is not a panacea for investing during crisis periods.
There is no shortage of hypotheses as to what characteristics define a stock that will outperform in a bear market. Some argue that value stocks should perform well, given their relative valuation buffer (the “less far to fall” argument). Some argue for a focus on balance sheet strength while others argue that cash-flow is the ultimate life blood of a company and should be prioritized. There are even arguments for industry preferences based upon economic cyclicality.
Each recession and crisis is unique, however, and therefore the characteristics of stocks that fare best will likely change. For example, the dot-com run-up caused a large number of real-economy businesses to be sorted into the “cheap” bucket of the value factor. These companies also tended to have higher quality earnings and lower beta / volatility than the dot-com stocks.
Common sense would indicate that unconstrained value may be a natural counter-hedge towards large, speculative bubbles, but we need only look towards 2008 – a credit and liquidity event – to see that value is not a panacea for every type of crisis.
It is for this reason that some investors prefer to take their cues from market-informed metrics such as beta, volatility, momentum, or trading volume.
Regardless of approach, there are some philosophical limitations we should consider when it comes to expectations with defensive equity portfolios. First, if we were able to identify an approach that could avoid market losses, then we would expect that strategy to also have negative alpha.1 If this were not the case, we could construct an arbitrage.
Therefore, in designing a defensive equity portfolio, our aim should be to provide ample downside protection against market losses while minimizing the relative upside participation cost of doing so.
Traditional linear sorts – such as buying the lowest volatility stocks – are coarse by design. They aim to robustly capture a general truth and hedge missed subtleties through diversification. For example, while some stocks deserve to be cheap and some stocks are expensive for good reason, naïve value sorts will do little to distinguish them from those that are unjustifiably cheap or rich.
For a defensive equity portfolio, however, this coarseness may not only reduce effectiveness, but it may also increase the implicit cost. Therefore, in this note we implement non-linear techniques in an effort to more precisely identify combinations of characteristics that may create a more effective defensive equity strategy.
The Strategy Objective
To start, we must begin by defining precisely what we mean by a “defensive equity strategy.” What are the characteristics that would make us label one security as defensive and another as not? Or, potentially better, is there a characteristic that allows us to rank securities on a gradient of defensiveness?
This is not a trivial decision, as our entire exercise will attempt to maximize the probability of correctly identifying securities with this characteristic.
As our goal is to find those securities which provide the most protection during equity market routs but bleed the least during equity market rallies, we chose a metric that scored how closely a stock’s return reflected the payoff of a call option on the S&P 500 over the next 63 trading days (approximately 3 months).
In other words, if the S&P 500 is positive over the next 63 trading days, the score of a security is equal to the squared difference between its return and the S&P 500’s return. If the market’s return is negative, the score of a security is simply its squared return.
To determine whether this metric reflects the type of profile we want, we can create a long/short portfolio. Each month we rank securities by their scores and select the quintile with the lowest scores. Securities are then weighted by their market capitalization. Securities are held for three months and the portfolio is implemented with three tranches. The short leg of the portfolio is the market rather than the highest quintile, as we are explicitly trying to identify defense against the market.
To create a scalable solution, we restrict our investable universe to those in the top 1,000 securities by market capitalization.