- Volatility and losses marred the first quarter of 2022 after two years of mostly solid gains.
- But O’Shaughnessy Asset Management’s (OSAM) defensive stability strategy held up admirably.
- Here are three sectors to watch for stability, according to OSAM’s Euan Mackay.
The first quarter of 2022 is in the books. Unfortunately for investors, this was the first three-month period in the red for the US stock market since the start of 2020.
Concerns about slowing economic growth, rising inflation, a more hawkish Federal Reserve and the Russian-Ukrainian war drove stocks lower and stocks rallying.
But this tougher environment helped O’Shaughnessy Asset Management’s (OSAM) “defensive stability” strategy to outperform its benchmark Russell 1000 index from Nov. 19 to March 31 by 4.7%, while reducing the volatility of 5.4%. The defensive stability strategy was down 0.2% over the period, while the Russell 1000 was down 4.9% and the S&P 500 was down 3.5%.
In the great debate between bulls and bears over whether or not a
happens, OSAM is agnostic. The quantitative
The company, which was acquired by Franklin Templeton in early 2022, instead uses a proven, data-driven approach to building portfolios, Euan Mackay, an OSAM client portfolio manager, said in an interview with Insider.
The firm has several factor strategies that get the job done for institutional investors and financial advisers by “taking the emotion out of investing,” Mackay said. This means investors don’t need to have a strong opinion about the future of stocks or the economy.
“Rather than making a call on the market’s near-term outlook, we’re really alerting people: Defensive stocks make sense,” Mackay told Insider. “You don’t have to be a bear for this strategy to make sense.”
Mackay continued, “If you have a long enough investment horizon, defensive stocks are a much more effective way to gain market exposure than just a passive index strategy.”
Defense wins championships
OSAM’s defensive stability strategy is built on this idea of getting “market exposure with much less risk,” Mackay said. Historically speaking, staying out of stocks altogether has proven to be a bigger mistake than going all-in at the height of the market. But portfolio managers still need to prepare for downturns and volatility through effective risk management.
“Defensive stability is one of those strategies where we see that – over long periods of time in the market, whether it’s up or down – the highest quality stocks, the most stable, outperform fairly consistently over long periods of time,” Mackay says. “And they do it very regularly with less risk.”
OSAM assesses whether stocks are high quality and stable across three measures: a company’s operations, management and trading volatility.
Mackay said operations are evaluated by a company’s health and revenue stability; management is judged by capital allocation decisions and whether they dilute shareholder value by issuing debt or equity; and volatility is judged by both the stock’s beta and the standard deviation of its past returns.
3 defensive sectors around which to build your portfolio
Mackay may not be allowed to reveal all the secrets of the model that crafted OSAM’s Defensive Stability Portfolio, but he did share three areas that stand out for stability: basic consumption, Health careand non-cyclical industrials. Conversely, the portfolio is underweight consumer discretionary and volatile information technology stocks.
Consumer staples stocks tend to outperform during market weakness because demand for essential goods like groceries and household supplies is not economically sensitive. This makes the group both defensive and less volatile, Mackay said, making it a natural part of the portfolio.
Exchange-traded funds (ETFs) related to the consumer staples sector include the Vanguard Consumer Staples ETF (VDC) and the Invesco Dynamic Food & Beverage ETF (PBJ).
Likewise, many parts of the
are on the defensive because the demand for goods and services that save and improve lives does not dry up during an economic downturn. However, Mackay noted that not all parts of the healthcare industry fit that mold. He cited biotech stocks as an example of companies that aren’t what he’s looking for, because often highly speculative losses aren’t seen as defensive or stable.
Some ways to gain exposure to the healthcare sector include ETFs like the Health Care Select Sector SPDR Fund (XLV) and the iShares US Medical Devices ETF (IHI).
Although generally considered cyclical, the industrials sector is full of stocks that aren’t economically sensitive, Mackay said. Aerospace and defense are a prime example of a defensive industry within industries, the portfolio manager said, adding that these stocks are less volatile than their peers.
Major aerospace and defense ETFs include the SPDR S&P Aerospace & Defense ETF (XAR) and the Invesco Aerospace & Defense ETF (PPA).
And while hindsight shows any portfolio’s returns would have been enhanced by adding exposure to the burning energy sector, Mackay said the once-defensive group would have been a poor fit in OSAM’s defensive stability portfolio. .
The wild volatility in oil prices during the first quarter of the year translated into eye-popping gains of 37.7%; only one other sector ended this three-month period in the green. But the sector’s wild swings disqualified energy stocks from the defensive stability portfolio in the first quarter. The unknown trajectory of the Russian-Ukrainian war means oil price volatility may not be over anytime soon.