No one likes being down, as nearly all investors are this year in their equities holdings. But some defensive strategies have escaped the worst ravages of this year’s slumping stock markets.
“Defensive attributes really come in various forms,” said Karl Cheong, head of distribution with Toronto-based First Trust Portfolios Canada, whose equity offerings include a suite of “buffer” ETFs that provide partial protection against market losses while not making sector bets.
For the most part, though, lower-risk equity ETFs are defined by their holdings. “Having a higher weight in defensive sectors and a lower weight in cyclical sectors are the hallmark of low-volatility or defensive portfolios,” said Chris Heakes, director and portfolio manager with Toronto-based BMO Asset Management Inc. Typically, this will result in overweighting sectors such as utilities and consumer staples, and underweight positions in cyclicals such as energy and materials stocks.
In selecting individual holdings, defensive investors should favour companies with relatively high profit margins and relatively low commodity exposure, said Paul MacDonald, chief investment officer and portfolio manager with Oakville, Ont.-based Harvest Portfolios Group Inc. Another characteristic of these companies is that demand for their products and services remains relatively stable, regardless of market.
Utilities stocks, for example, have performed relatively well despite often being considered yield sensitive in a rising rate environment. “The market seems to be paying more for the consistency and certainty of cash flows,” said MacDonald, whose firm’s offerings include the Harvest Equal Weight Global Utilities Income ETF.
Size also matters for Harvest, which has a strong bias in favour of companies with market capitalizations of more than $10 billion. “In the large companies you have proven abilities to really execute across market cycles and often product lineups that are diversified,” MacDonald said. Historically, he added, large-cap companies have been successfully made acquisitions during periods of market weakness.
Another characteristic associated with defensive investing is dividend-focused strategies. “They can be another way to build out a defensive portfolio,” said Heakes. He cited the BMO Canadian Dividend ETF as an example of a portfolio of large-cap Canadian companies including banks, pipelines and telecommunications companies.
“They’re growing but they still have that ability to return capital to shareholders in the form of dividends or [share] buybacks,” Heakes said. “We expect the dividend stream to remain smooth and even increase a little bit over time. So it does add some stability to the portfolio.”
The ETF’s annualized distribution yield was 4.48% in late September, about 110 basis points higher than BMO’s broad Canadian equity index ETF. Its one-year return to Sept. 30, though only narrowly positive at 1.2%, beat its index counterpart by more than 6.5 percentage points.
Covered call writing, while reducing potential capital gains, can also reduce risk while generating tax-efficient premium income. Among the equity ETFs that offer these options overlays are those that are part of the BMO, Brompton, CI, Evolve, Harvest and Horizons families.
“When returns are very difficult to come by in the market, that covered-call strategy and the incremental cash flow that you can earn is really a component of a total return strategy,” MacDonald said.
Harvest’s covered-call equity ETFs can write call options on up to 33% of the assets of each holding. “We want to have the ability to generate our fixed monthly distribution,” MacDonald said, “but at the same time keep that long bias.”
Various ETF companies offer low-volatility ETFs that have explicit mandates to deliver lower standard deviations of returns and reduced sensitivity to rising interest rates than the broad markets. Providers include the BMO, Brompton, CI, CIBC, Fidelity, Invesco, iShares, TD and Vanguard families.
For example, the suite of low-volatility ETFs sponsored by Toronto-based Invesco Canada Ltd. encompasses Canadian, U.S. and overseas markets. As is typical for low-vol strategies, stock selection is based on screening for low standard deviations. “These strategies tend to historically gravitate toward safer sectors,” said Darim Abdullah, vice-president and ETF strategist with Invesco Canada.
“The idea of low-vol strategies is to help clients potentially reduce the overall volatility and the overall downside capture ratios relative to the broad-based market,” Abdullah said. These strategies have done so, he added, over both long-term periods and in the year to date.
The most distinctive defensive equity strategy is that of First Trust. Its buffer ETFs provide exposure to the broad S&P 500 index of U.S. stocks in combination with options that limit both gains and losses over a one-year period.
In its latest one-year renewal in August, the three-year-old First Trust Cboe Vest U.S. Equity Buffer ETF – AUG was subject to a cap of 20.46% on returns before fees. More importantly for defensive investors, any losses would be reduced by 10 percentage points. In the year to date, this ETF made the U.S. bear market much less painful. Its 14% loss was nearly 10 percentage points less than the S&P 500’s plunge.
First Trust’s Cheong said buffer ETFs provide investors with the performance and risk profile of what a 60/40 portfolio of equities and fixed income should achieve, but hasn’t in this market environment in which both stocks and bonds have declined by double-digit percentages.
He said the buffer strategy is more quantifiable and predictable than low-volatility stock selection, and can provide protection in any market environment. “There’s really no better option for an equity investor who wants to invest defensively but doesn’t want to be choosing a particular sector or style.”