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The 4 New Defensive Strategies

February 22, 2013

by Russ Koesterich

of iShares Blog

Year-to-date investors have had few reasons to play defense. Stocks, at least in the United States, have rallied and credit continues to hold its own.

That said there are market risks not too far down the road. There’s the late February Italian elections, the upcoming sequester, not to mention the potential for disappointing US first-quarter growth and worsening Middle-East turmoil.

While I remain optimistic that 2013 will ultimately prove to be a good year for risky assets, for those investors looking to protect their recent gains, here are four suggestions:

  1. Don’t overpay for defensive sectors. While some asset classes are safer than others, many of the safest ones are currently very expensive. In particular, I would avoid overpaying for classic defensive sectors like consumer staples and utilities. The latter, currently trading at a 7% premium to the broader market, looks particularly overpriced and risky. Historically, this slow growing regulated sector traded at an average discount of more than 20%.
  2. Don’t focus on sectors, think about strategy. Rather than overpay for a particular sector or stock, I would prefer employing defensive strategies, like minimum volatility. For example, the 30-day trailing volatility on the iShares MSCI ACWI fund (ACWI) is more than 8%. The volatility on the corresponding minimum-volatility strategy, the iShares MSCI Global Minimum Volatility fund (ACWV), is under 5%. In addition, historically the minimum volatility approach has delivered better risk-adjusted returns over the long term.
  3. Know where to get more fixed income. While most fixed income looks expensive, there are some places to hide. On a relative basis, investment grade and municipals offer some yield and have generally exhibited much lower volatility than equities. By way of comparison, the trailing one-year volatility on a broad US or global fund is approximately 13% to 15%[1], while the iShares Investment Grade Corporate Bond fund (LQD) and the iShares National AMT-Free Muni Bond fund (MUB) have a trailing one-year volatility of 5%.
  4. Know when to consider adding to Treasuries with a twist. While I believe that Treasuries are an awful value in the longer term, they do provide clear diversification when markets slump. As such, in the case of a real crisis, and not just a growth scare, investors may want to consider adding to their positions in US Treasuries and employing this strategy with a slight nuance by opting for Treasury Inflation-Protected Securities (TIPS). Treasuries have become more volatile of late. In contrast, over the past year, we’ve seen considerably less volatility in TIPS funds.

To be sure, of the asset classes I advocate for above, Treasuries and TIPS are the only ones likely to appreciate in the midst of a crisis. But in the event of a market correction, all four of these strategies should potentially add ballast to a portfolio and help cushion the downside.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.

Minimum Volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Bonds and bond funds will decrease in value as interest rates rise, and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. Treasury funds are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

[1] As measured by the one-year trailing standard deviation of the iShares Core S&P 500 ETF (IVV), according to BlackRock data.

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