- Until recently, some Russian-exposed stocks had low betas and so seemed defensive – but they've fallen sharply
- There have always been risks in defensive stocks, but investors are on average rewarded for taking these risks.
Some apparently defensive stocks aren’t defensive after all. That’s the message of the collapses in the share prices of companies with significant interests in Russia such as Eurasia Mining, Petropavlovsk and Polymetal.
The thing is that, until recently, these shares had low betas; they tended not to covary much with moves in the All-Share index. They were, by that measure, defensive. Of course, they were risky in another sense; doing business in Russia is dangerous even in peacetime. But these risks were only lightly correlated with ordinary market risks – hence their low betas.
That apparent defensiveness, however, was misleading. Thanks to slumps in these, my no-thought defensive portfolio has horribly underperformed recently.
It's unclear that a different approach to defensive stock-picking would have avoided this. Yes, some ethical investors would have steered clear of Russian-linked stocks for years. But they would also have avoided military stocks such as BAE Systems or commodity producers such as Shell or Rio Tinto, which have risen so far this year. For this reason, while some ethical funds such as Family Charities have performed relatively well in recent weeks, others – including some green funds – have not.
Yes, a more intuitive approach to defensiveness would have helped. It would have kept us out of Russian stocks, which have for a long time felt risky whatever the statistics say. And it might well have got us into stocks such as Shell or HSBC which felt safe because of their familiarity and fat dividends and which have indeed done well recently.
But such a strategy would have done horribly at the start of the pandemic in 2020. Back then Shell and HSBC fell sharply as their dividends were cut. My no-thought statistics-based portfolio avoided these and did well as a result. If intuition beat statistics this year, the opposite happened two years ago.
Which gives us a problem. Neither statistics, nor intuition, nor ethical considerations can reliably tell us what actually will be a defensive share.
This is a general problem. A defensive stock is one that holds up well when the market falls. But which precise stocks these will be depends upon why the market falls. Arms stocks, for example, have done well recently, but they are not always defensive simply because economic downturns that hurt the market often also cut governments’ demand for arms, not least by cutting the oil price. Similarly, before 2020 transport stocks were seen as relatively defensive, but they became riskier during the pandemic. And before 2007 banks, mortgage lenders and housebuilders were not seen as especially risky, until the financial crisis called into question their very existence.
Just because a stock has been defensive in the past, therefore, does not mean it will be so in future. Polymetal this year and Shell in 2020 both tell us this. In this sense, defensives are riskier than they seem.
This risk comes on top of another danger, which is that even if your portfolio of defensive stocks remains defensive it could underperform a sharply rising market. This is bad news for those fund managers whose pay and job prospects depend upon their relative performance.
But here’s the good news. On average and over the long run, investors are rewarded for taking on these risks. My chart shows that even after their terrible performance, defensive shares have still beaten the market over longer periods – by just under one percentage point per year over the last 10 or 15 years.
This is not an isolated finding. Nardin Baker and Robert Haugen, plus a team of economists at Robeco Quantitative Investments, have shown that defensives outperform around the world. And the Nobel laureate Myron Scholes has shown that the same was true of US stocks between the 1930s and 1960s. The long-term outperformance of defensive stocks is a robust fact, which is true of different times, places and definitions of defensiveness.
By contrast, other types of risk do not pay off. Economists at AQR Capital Management have shown that high-beta shares (those which carry lots of market risk) do badly on average. Harvard University’s John Campbell has documented the underperformance of stocks on the verge of bankruptcy. And of course risky Aim stocks have for years underperformed the main market.
It is in this respect that defensive shares are unusual. Their virtue is perhaps not that they are always less risky than other stocks. It is that we are at least on average compensated for taking those risks. Which is more than can be said for many other segments of the market.
