For years, economists such as MIT’s Ricardo Caballero and Harvard’s Emmanuel Farhi have discussed the shortage of safe assets, the phenomenon which has contributed to bond yields falling since the 1990s. What’s not so well appreciated, however, is that the safe asset shortage also afflicts the UK equity market; there are fewer defensive stocks than there used to be.
Simple statistics tell us this. If we measure betas by monthly returns over five years the most defensive FTSE sectors now are transport and non-life insurance, both with betas of 0.5. In the early 2000s, however, six sectors had betas lower than this – and all have seen their betas rise.
| Changing betas | ||
| Beta wrt All-Share index | Now | To Sep 04* |
| Beverages | 0.87 | 0.21 |
| Food producers | 1.04 | 0.36 |
| Food retailers | 0.93 | 0.36 |
| Utilities | 0.74 | 0.36 |
| Tobacco | 1.29 | 0.37 |
| Pharmaceuticals | 1.13 | 0.37 |
| Healthcare | 0.62 | 0.77 |
| Transport | 0.51 | 0.89 |
| Non-life insurance | 0.50 | 1.40 |
| *Chosen because the coefficient of variation of betas was highest then | ||
| Based on five years of monthly returns | ||
To put this another way, what we’ve seen since the early 2000s is beta compression. High beta sectors don’t have such high betas as they had then, and low beta ones don’t have such low ones.
To see one reason for this, imagine there were to be a liquidity crisis in which investors needed to raise cash urgently. In their panic to do so they would sell anything they could. Because large 'defensive' stocks tend to be more liquid than others their prices might at least initially fall as much as others. Economists at AQR Capital Management say this has an obvious implication – that if investors are worried about liquidity risk, stocks’ betas would be around one because even stocks which are safe in other regards would be vulnerable to fire sales. It’s perhaps no accident that we’ve seen beta compression since the 2008 crisis, because that reminded everybody that liquidity risk is real and nasty.
There’s a second reason for beta compression, though: investors have wised up. Years ago, and especially during the tech bubble, investors who became more optimistic would buy growth stocks and sell duller ones which they thought had gone ex-growth such as tobacco. That caused a big difference in betas. Growth stocks such as IT ones rose a lot when the market rose, and dull ones such as tobacco and utilities rose only slightly if at all.
The tech crash, however, reminded investors that this strategy was mistaken. Growth stocks are often overpriced. And as Warren Buffett has said, mature stocks can grow nicely if they have “economic moats” (sources of monopoly power) to fend off potential competitors. Having learned these lessons, investors are less likely to buy 'growth' stocks when optimism rises and less likely to sell duller stocks. This has led to beta compression: growth stocks don’t rise so much when the market rises, and defensives don’t lag behind so much.
In fact, this process has added another risk to defensive stocks: wising up risk. Big defensives such as Diageo, Uniliever and Reckitt Benckiser have done well in recent years because investors have learned the value of economic moats. But they might have learned the lesson too well. Such big run-ups mean these shares might have become overpriced.
A further reason why defensives aren’t as defensive as they used to be is political risk. It used to be the case that utilities were defensive. With the Labour party threatening to nationalise them, perhaps on unfavourable terms, however, such security is no longer guaranteed. And other erstwhile defensives face the risk of tougher regulation.
All these factors together mean that there are no longer obviously cheap defensive stocks.
This implies that it is harder to spread risk by holding equities alone. We can no longer rely upon some defensives to significantly outperform a falling market. If you want to reduce equity risk you must therefore hold non-equity assets. In fact, the recognition of this fact might be one reason why bond prices are so high: investors look to these for protection against equity bear markets.
Another problem is that the lack of obvious defensives mean it is harder now to beat the market. For decades and around the world defensive stocks have done better than they should. There’s a good reason why this should be: fund managers who are judged and paid by relative performance are reluctant to hold defensives for fear they will underperform a strongly rising market.
Exploiting this effect, however, has become harder. Several equity income funds have discovered this lately. According to Trustnet, over a quarter of these have lost money in the last 12 months even though the All-Share index and FTSE 350 high yield index have given a positive total return. One reason for this is that it is harder to find good high-yielding defensive stocks. The days when you could build a nice high-yield defensive portfolio around tobacco and utility stocks are gone.
None of this means the tendency for defensives to beat the market has disappeared. Instead, the fact that it’s harder to spot defensives these days means it is harder to implement defensive investing. There’s often a big gap between what works in theory and what works in practice. For defensives, it has got bigger.
