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Sector Watch: Spotlight on Defensive Strategy

About four and a half years ago, Folio Investing launched an equity (e.g. stock) portfolio that focused on reducing the impact of market volatility.  So-called defensive stocks are those which tend to be fairly insensitive to the mood of the market as a whole.  Conventional wisdom suggests that demand for band-aids, electricity and paper does not go up when the market is exuberant, but neither does it collapse when the market swoons.  The conventional wisdom also suggests that these stocks will tend to under-perform the broader market during rallies and, over the long-term, that a portfolio of these stocks will deliver modest returns.  Our research suggested, however, that it was possible to create a portfolio of defensive stocks that would provide returns to keep up with rallies in the broader market, while still substantially reducing the impact of market volatility.  Folio Investing launched the Defensive Strategy Folio that incorporated this research on February 28, 2008.


From February 28, 2008 through September 5, 2012, the Defensive Strategy Folio has provided an annualized return of 6.28% vs. 2.72% per year for the S&P 500 (including dividends).  The Defensive Strategy Folio has performed well over a 4.5-year period during which the S&P 500 has struggled.  This is what we expect for a defensive strategy.  What is truly notable, however, is that the Defensive Strategy Folio has kept up with the robust rally in the S&P 500 over the past three years as well.  The chart below shows the total return for an investment in the S&P 500, assuming dividends are reinvested, from August 31, 2009 through August 30, 2012.  Over the period, the S&P 500 has returned a cumulative 46.7% (annualized return of 13.6% per year).  Over the same three-year period, the Defensive Strategy Folio has slightly out-performed the S&P 500 with a total return of 48.3% and has done so with less volatility.  As the chart below illustrates, the Defensive Strategy Folio has followed the broad rally but has not swung up or down as much as the S&P 500 during short-term rallies and drops.  The chart of the Defensive Strategy performance is for funded performance for an account maintained at Folio Investing.

Defensive Strategy Folio vs. S&P 500 (8/31/2009-8/31/2012) Defensive Strategy Folio vs. S&P 500 (8/31/2009-8/31/2012)

There are a number of possible explanations for the substantial out-performance of the Defensive Strategy since it was launched in February of 2008.  Certainly, there is an element of chance.  This Folio was introduced shortly before one of the worse market crashes in history and defensive industries tend to thrive in these conditions.  Our research in 2007 suggested that the Defensive Strategy would out-perform in down markets but also would out-perform the S&P 500 across a range of market conditions.  The fact that the Defensive Strategy Folio has slightly out-paced the S&P 500 during its impressive three-year rally supports our conclusions.

Strategy Overview

The Defensive Strategy Folio is not simply a collection of stocks picked from defensive sectors.  A key part of our analysis was to combine securities in the Folio that provided effective risk offsets.  In other words, these stocks were selected both on the basis of their individual attributes, and on how well they worked together to mitigate risk.  This was accomplished using a sophisticated statistical analysis that accounts for the correlations and risk levels of each stock on a trailing historical basis and using forward-looking Monte Carlo simulations.

On an individual basis, the stocks that comprise the portfolio tend to have low Beta, a statistical measure of how much the returns on a stock are driven by the broader market.  Defensive stocks tend to have low Beta.  The current Beta for the entire Folio is 73% as compared to 100% for the S&P 500.  There is a growing body of research that finds that low-Beta stocks out-perform their higher-beta counterparts (which are often ‘growth’ stocks) over the long run.  This research supports our own findings, albeit on the basis of a different line of reasoning.

Portfolio Holdings

The Defensive Strategy Folio consists of large, established companies that are engaged in businesses that are less affected by periods of economic growth and decline.

Symbol Company Weight
ABT Abbott Labs 6.30%
ADM Archer Daniels Midland Co 6.38%
AFL Aflac Inc 6.38%
CL Colgate Palmolive 5.32%
D Dominion Resources Inc. 5.32%
GSK GlaxoSmithKline Plc 6.00%
HRL Hormel Foods Corp 5.32%
JNJ Johnson & Johnson 5.32%
LMT Lockheed Martin Corp 5.32%
PEG Public Svc Enterprise Group 6.00%
PEP Pepsico Inc 5.32%
PGR Progressive Corp Ohio 6.60%
SO Southern Co 5.32%
UNH Unitedhealth Group 6.38%
VLO Valero Energy Corp New 5.32%
WAG Walgreen Co 6.40%
WMT Wal Mart Stores Inc 7.00%

Source: Folio Investing
[Note: The holdings are re-evaluated and updated (as needed) on a quarterly basis.]

Commentary: The Case for the Defensive Strategy

There are a variety of reasons why the type of strategy used in this portfolio may be attractive in the future.  First, while the economy is recovering from a deep recession, the economic growth as we emerge may continue to be modest.  In addition, the overhang of consumer debt may substantially limit the rebound of discretionary consumer spending.  For these reasons, companies which provide necessary basic products and services are quite likely to out-perform relative to stocks of companies that sell discretionary products.  While this narrative is plausible, any type of economic forecast is fraught with uncertainty.  The Defensive Strategy Folio allows investors to participate in economic recovery and growth, as we can see by the performance over the past three years, as well as providing some protection from market volatility.


The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.

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