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Why defensives are best

Taking risk doesn’t pay. I say this because in the last five years there has been a significant negative correlation across FTSE sectors between returns and beta. Sectors with high betas – that is, those that carry lots of market risk – have generally delivered lower returns than those with lower betas. The high beta oil and gas, travel and leisure and life insurance sectors, for example, have underperformed low beta sectors such as beverages and pharmaceuticals.

This hasn’t happened because market risk has actually materialised in this time: the All-Share index is higher now than five years ago. Nor is it because one or two outliers distort the pattern; my chart shows that this is not the case. Nor is it an effect of Covid. True, that explains the catastrophic drop in travel stocks in 2020, but investors should have been rewarded before then and since for taking on their risk. But they were not.


What’s more, this negative relationship between beta and returns is not new. We saw the same pattern, albeit to a slightly lesser degree in the previous five years, from 2011 to 2016 – a time when aggregate market risk paid off well as the All-Share index rose 35 per cent. Despite that, the high-beta mining sector then (for example) under-performed low-beta beverages, food producers and healthcare stocks.

What we have here is another dimension (and therefore yet more evidence of) a general fact – that defensive stocks do better than they should. My portfolio of low-risk stocks, for example, has beaten the FTSE 350 by 20 percentage points in the last five years.

Which of course is not a recent phenomenon, nor one confined to the UK. Economists have shown that defensive stocks have done better than they should in the US since the 1930s and around the world since the 1990s. This fact is robust to different definitions of defensiveness.

Which poses the question: why?

It’s sometimes said that investors are disproportionately drawn to glamorous stocks which offer the chance of big gains, with the result that dull defensives are under-priced.

This is true of Aim shares. And it’s also true of many defensives: a portfolio of the likes of Diageo (DGE), Renishaw (RSW) and AstraZeneca (AZN) won’t excite people at dinner parties but it has done a nice job. But it isn’t the whole story: BP and Aviva haven’t underperformed because they were once considered to be thrilling shares.

Nor, I suspect, can we attribute this pattern to the fact that investors have under-appreciated the virtues of monopoly power, causing monopoly-type stocks to out-perform in recent years. Yes, this might explain the success of AstraZeneca or Diageo. But I’m not sure it explains the good performance of electronic stocks or the bad performance of the oil majors.

Another possible explanation is that stocks’ betas can suddenly change so a defensive stock can cease to be so. Transport stocks, for example, were defensive until the pandemic caused them to become much riskier.  Fearing such increases in risk, some investors shun defensives with the result that they give good returns to those brave enough to buy them.

Again, though, there are problems with this theory. For one thing, several low-beta sectors, such as beverages, have had stable betas. And for another, why should there be a greater risk premium on stocks that might become risky than there is on those that actually are risky?

There’s another theory, proposed by economists at AQR Capital Management. Many investors, they say, cannot borrow as much as they would like. When they are bullish they therefore take a geared position on the market not by borrowing to buy shares generally, but simply by overweighting high-beta stocks – those that would rise most if the market rises a lot. This causes these to be overpriced and low-beta stocks to be under-priced with the result that high-beta shares under-perform low-beta ones. As so often in the social sciences, behaviour that seems sensible for any individual is collectively self-defeating.

Yet again, though, there’s a problem here. AQR economists pointed this out back in 2013, and the out-performance of defensive stocks was well-known before even then. Which poses the question of why investors haven’t wised up to this mispricing and thus corrected it, as they have with other mispricings.  

Which leaves one other possibility – that defensives are in fact risky. If you are a professional fund manager holding them you risk underperforming your rivals if the aggregate market does very well – and that means losing business and perhaps even your job.

If this explanation is correct, it’s great news for retail investors. We don’t have to worry about the risk of shortish periods of relative underperformance and so for us defensives aren’t so risky. Which means we can buy them and earn ourselves a risk premium for a risk that shouldn’t bother us. That’s getting something for nothing.

We don’t have many advantages over big professional fund managers, but this might well be one.