The shift in defensive investing 

2020 has seen significant headwinds. Sectors that have traditionally been viewed as defensive are no longer considered safe havens.

Energy is one example. This high yielding sector has been among the hardest hit during the COVID-19 pandemic and continues to see bouts of volatility amid supply and demand uncertainties.

In contrast, Amazon, which used to be regarded as a volatile tech stock in its early days, is one of several high growth companies that have matured into large diversified businesses and acted somewhat defensively as they benefited from stay-home policies.

These changes in the investment landscape have sparked a debate on what now constitutes a defensive stock.

 

Why invest in defensive equities?

Many investors use equities as a way to access strong returns. However, navigating the inevitable market declines and paying attention to the downside are important factors to consider when journeying towards long-term investment success. 

The example below shows how downside capture impacts returns by considering two portfolios that track the MSCI World Index. The portfolio that captures only 90% of the index return in months in which it was negative would have achieved a cumulative return of more than double the index since 31 December 1969. However, the portfolio that has a downside capture of 110% would have seen the wealth halve in value compared with the index’s returns.

 

The impact of downside protection on long-term returns

The value of a hypothetical US$10,000 invested at launch of MSCI World

Past results are not a guarantee of future results. For illustrative purposes only. Investors cannot invest directly in an index.
Downside capture measures monthly return during periods of negative market returns, divided by the market return. A number below 100% indicates returns above the market.
Data as at 31 May 2020. Cumulative returns in USD terms. Sources: Capital Group, MSCI

 

Given the uncertainties ahead of us and the importance of protecting on the downside, it begs the question: Will the traditional defensive sectors continue to serve investors well in the future? The answer to this may depend on the cause of the downturn.

Looking at the last eight market declines of more than 10%, our analysis shows that sectors such as consumer staples, utilities, health care and communication services have held up relatively well against the overall market.

 

Sector returns during the last eight market declines greater than 10%
 

Past results are not a guarantee of future results.
Includes the eight periods that the MSCI World Index (with net dividends reinvested) declined by more than 10% in US$ terms, using monthly periods from 30 June 1998 to 31 March 2020. Excess returns used in the calculation for average excess return versus the index are annualised for periods greater than twelve months. Before 24 September 2018, the communication services sector was called telecommunication services and the company composition was materially different. Sources: MSCI, FactSet

 

But the picture is different if we examine the underlying industry and individual stock return differences. Utilities, for example, turned out to be one of the most volatile of all industries during the COVID-19 crisis, despite typically being regarded as a defensive sector. Furthermore, stocks in a supposedly defensive sector like consumer staples have varied greatly in volatility.

Case studies on market downturns such as the bursting of the dot-com bubble, the global financial crisis and the economic slowdown in China revealed a similar pattern of unexpected sectors emerging stronger despite not having a good track record of preserving value during weak market conditions. 

The investment landscape became more uncertain when dividend-paying and value companies acted less defensively than expected during recent periods of market volatility. For instance, value stocks are no longer a straightforward, less-risky decision – looking back over the past 10 years, they have been more volatile compared to the broader market.¹ Dividend payers, on the other hand, are facing structural headwinds. Examples include oil companies facing a potential long-term decline in global oil demand, while telecoms are experiencing high capital expenditure requirements in their business.

These examples shed light on the importance of fundamental research into individual companies in order to identify the ones that can weather a downturn, rather than relying on a sector-level defensive strategy.

 

1. Data based on monthly periods for the 10 years from 30 April 2010 to 30 April 2020 using standard deviation as a measure of return dispersion. Indices used are MSCI World Value Index (with net dividends reinvested) and MSCI World Index (with net dividends reinvested) in US$ terms. Source: Morningstar Direct

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.