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defensive equity strategy

May 2023

Marketing Material

Defensive equities come into their own in times of market upheaval. But not all defensive strategies are alike. The challenge facing investors building lower risk equity portfolios is to avoid one-dimensional approaches – such as simply targeting low volatility – while also maintaining diversification and minimising correlation. And, crucially, generating strong returns with sustainable assets.

The Quest Global Equities strategy is designed to help defensively-minded equity investors to spread their risks, while maintaining healthy prospects for returns. That’s particularly important in an environment of high inflation and rising interest rates – which is when equity markets tend to struggle.

A new era of macro risk

For most of the period since the global financial crisis of 2008/09, growth-oriented equity strategies made hay, outperforming the wider market by an average of 2.1 percentage points per year since 2010.¹ That was a by-product of zero interest rate policies. But with inflation having recently surged to multi-decade highs across much of the world, central banks have had to put the brakes on their economies with sharp interest rate hikes. High and rising interest rates have called into question the rich valuations that characterise growth stocks. Investors raced to value instead. Yet this created another problem – a strong relationship between the two strategies, albeit a negative correlation, that undermines efforts at portfolio diversification.

One solution is to identify defensive stocks whose returns don’t correlate with those of other types of equity. Such investments would be a valuable addition to an equity portfolio – not least because an analysis of the equity investment universe shows that investment styles tend to cluster. For instance, there are clear and significant groups of growth- and value-oriented funds.

For its part, Quest’s return profile exhibits a very low correlation with both the growth and value cohorts.

Quest’s defensive characteristics also mean that it tends to outperform in otherwise challenging environments for equities (see Fig. 1).

Quest chart — Source: Pictet Asset Managment, MSCI World. *Performance is based on a representative portfolio in the Quest Global Sustainable strategy. Performance stated is net of dividend, before fees in USD. Returns are not chronological but ranked in order of worst to best MSCI World monthly performance. Data from 30.12.2012 to 28.04.2023. Past performance is not a guarantee or a reliable indicator of future performance. Performance data does not include the commissions and fees charged at the time of subscribing or redeeming shares. The client’s returns will be reduced by the management fees and other expenses.

But because this is an active strategy that assesses defensiveness across four distinct dimensions, Quest also manages to keep pace with the wider market during its recovery phase, unlike passive defensive strategies whose performance drops off during rallies. It is only during the last, boom phase of markets that Quest underperforms the wider market – though it still does significantly better than passive low volatility strategies.

Defensive alternatives

That’s particularly relevant now: although Pictet Asset Management’s strategists expect inflation to come back down towards central bank targets over the medium term, it won’t be a smooth path. This heightened inflation volatility is likely to dampen economic growth and therefore depress equity market performance for years to come.

At the same time, the more unstable growth and inflation is, the greater the risk for equities. So it makes sense for investors to hedge some of their broader equity portfolio with some defensive investments that are less vulnerable to the swings in the business cycle.

We believe the Quest strategy fits that profile.

Its key distinguishing feature is that it doesn’t take a single factor approach to investing. Although single factor strategies can be successful, these periods of excess returns are frequently ephemeral. But because investors also under-appreciate defensive stocks in general, there are consistent excess returns to be mined from companies with defensive characteristics. A balance here, however, needs to be struck between holding an appropriately diversified mix of defensive companies and having a sufficiently active share to make the most out of a bottom-up investment management approach.

ESG matters

An added benefit of Quest’s multi-factor defensive screen is that it tends to identify companies that score well on environmental, social and governance (ESG) factors.

Excluded from the portfolio are companies that derive their revenue from controversial products and activities deemed harmful to society and/or the environment, and which have severely breached international norms on human rights, labour standards, environmental protection, and anti-corruption.

In a market environment of heightened macro-economic uncertainty, it makes sense for investors to turn defensive.

The Quest team has also developed a proprietary ESG scoring model to gain a deeper understanding of the ESG risks of the companies that pass the initial screen.

The strategy can only invest in firms that score well on the aggregate across these dimensions. The end result is a portfolio with one of the highest MSCI ESG scores and lowest greenhouse gas emissions in the defensive peer group.

In a market environment of heightened macro-economic uncertainty, it makes sense for investors to turn defensive. It’s an approach that outperforms when the wider market struggles – as it’s likely to do now that central banks are removing excess liquidity from the financial system. Adding a defensive strategy to their portfolios gives investors the opportunity to secure equity returns that are uncorrelated with either growth- or value-oriented stocks.²

[1] MSCI growth vs MSCI all country world index average annual relative performance.

[2] Source: Pictet Asset Management and eVestment. Universe of 159 global managers from Jan 2013 to Sep 2022 from the eVestment database that are benchmarked against the MSCI World ND index and have a base currency of USD or EUR. Correlation calculated from monthly active returns of each manager and the active returns of the MSCI World Value total return index and MSCI World Growth total return index. Period used is from Pictet Quest Global Sustainable inception on 30.12.2012.

Following the prophets: identifying effective analyst recommendations

Our research shows following a certain cohort of sell-side analysts can yield a better investment outcome than the broader group as their recommendations tend to have a greater and longer-lasting impact on prices.

Reda Jürg Messikh, Thibault Jaisson

January 2023

Quest Equities

Customisable quantitative equity strategies managed with conviction, and a long heritage in integrating ESG

About

David Wright

David Wright joined Pictet Asset Management in 2022 and is Co-Head of Quest, Quantitative Business Strategy. Before joining Pictet, David spent 22 years at BlackRock (BGI before 2009), latterly as EMEA Head of Product Strategy for the Systematic Active Equity (SAE) business and the lead product strategist for SAE’s ESG products. Prior to that, David worked as a senior product strategist in London & New York representing the SAE business with institutions, intermediaries and consultants. Earlier in his BGI career he had roles in performance measurement and the RFP team. David has a Bachelor’s degree, in Economics from the University of Leicester.

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