The make-up of “quality” equity sectors have changed dramatically and investors should pay close attention to what goes into these strategies, research has warned.
Deep structural changes in economies and markets have influenced what portfolio managers define as quality investing, according to a report by investment manager Bfinance.
A defensive equity strategy is one that provides returns similar to equity markets, but with a lower level of risk.
These are often investments that have a low sensitivity to the broader economy, which for equities would be companies that have strong balance sheets, and do not experience as much share price volatility as the rest of the market.
In the report, entitled 'Defensive equity and market downturns: is this time different?', Bfinance’s director of public markets, Martha Brindle, said investors today are keen to understand how defensive equity strategies fare in inflation, and stagflation, periods.
The five types of defensive equity strategy
“While the early part of 2022 has been illustrative, one of the more notable drawbacks of historic performance and risk analysis is the lack of extensive credible data for periods of non-transitory inflation,” she said.
The report breaks down the strategies into five categories, which are low volatility, income, classic quality, quality value and quality growth, which Bfinance said was the least defensive.
A resilient equity strategy must be considered alongside the standard portfolio diversification, the report said, including fixed income, alternatives, hedge funds, and private markets strategies.
Ultimately, said Brindle, the effectiveness of these strategies will rely on how central banks manage the impact of interest rates on the economy.
“The outcomes will—to a great extent—depend on whether central banks are able to engineer that much-promised ‘soft landing’: higher interest rates without economic decline,” she said.
Passive quality investing
Exposure to low volatility, income and classic quality strategies can be gained through passive investing, the report added, but these factor indices are normally constructed using a “very narrow” set of fundamentals.
Using MSCI’s quality index as an example, the selected stocks are those that have a high return on equity, low leverage and low earnings variability.
“While these may be useful indicators of past quality, they are backward-looking,” the report said.
“They do not indicate a firm’s competitive advantage or its ability to defend, maintain and expand that advantage.”