Hidden risks of defensive investing

Eight years into a U.S. bull market, valuations are elevated and with them, the risk of U.S. stocks moving into bubble territory. In response, many investors have begun pouring assets into defensive approaches such as dynamic risk-based allocation strategies. However, could these defensive strategies actually be responsible for intensifying risk rather than mitigating it?

Investors got a taste of the potential for market disruption in August 2015, when the S&P 500 index tumbled 11% in little more than a week. The accompanying spike in volatility was by some measures among the largest in decades. It wasn't clear why the sell-off was so violent, but one possibility is that some strategies designed to help investors mitigate risk actually intensified it. These include volatility target strategies, some implementations of “risk parity” and portfolio insurance. The common characteristic of these approaches is that they're designed to reflexively and mechanically reduce the allocation to equities as the riskiness of the asset class or the overall portfolio increases.

It is important to recognize that these types of defensive approaches were originally conceived to regulate portfolio exposures in response to gradual, long-term changes in the market risk environment, not violent shifts. In some implementations, however, the equity allocation can be quite sensitive to a sudden surge in market volatility. As an example, the MSCI USA 10% Risk Control index determines equity exposure based on short-term trailing realized market volatility. In the August 2015 sell-off, which occurred against the backdrop of what had been a quiet market, such a mechanism likely would have triggered a sudden, severe reduction in equity exposure, perhaps in excess of 50% in a matter of days.

Moreover, these types of defensive strategies don't rebalance positions in a vacuum; as they delever, other defensive strategies might simultaneously generate programmatic selling. Portfolio hedging via options, for example, can result in such flows. Dealers that underwrite the protection assume long market exposure through their side of the trade. To keep it neutralized, they have to sell equities as stocks fall (and buy as stocks rise). As more investors secure protection against a future decline, the greater the potential selling pressure from the dealers if a sell-off actually does occur.

The severity of market swings during August 2015 triggered debate as to whether programmatic deleveraging from defensive strategies had grown large enough to influence market dynamics, exacerbating sell-offs and volatility. Some assessments ran into the hundreds of billions of dollars and were accompanied by eye-catching estimates of flows generated. While the jury is still out on the true magnitude of its impact, the August 2015 episode does highlight potential vulnerabilities investors should take note of when considering defensive strategies that hinge on mechanical, risk-based deleveraging.

First, they're vulnerable to timing and liquidity risks. They may sell into the teeth of — or even after — a sharp market decline, and releveraging might not begin until the market is well into recovery. Programmatically reducing exposure might consume market liquidity at times when uncertainty has both reduced the depth of the market and increased trading impact (symptoms clearly evident during the August 2015 episode). And while it might be prudent to reduce portfolio exposure as market risk and uncertainty increase, a key question under such circumstances is whether the market is offering sufficient or possibly even outsized compensation for the heightened risk. Moreover, inattention to valuation in a purely risk-driven model might even create vulnerability before a sell-off occurs. If an asset's volatility diminishes during a steady price rise, then an allocation model driven by a backward-looking risk measure might continue to increase its holding regardless of whether the asset's valuation has started to look unjustified.

Such vulnerabilities are a reminder that a robust allocation framework should ideally incorporate a rich risk forecasting model, sensitivity to liquidity conditions and a combination of macro indicators, valuations, and sentiment to assess how the market is pricing risk. A reductive approach that narrowly focuses on simplistic risk metrics such as recent realized volatility or the VIX likely will be insufficient.

In evaluating risk management approaches, investors should examine back tests with a critical eye, as some track records hinge on fortuitous market dynamics that might not be representative of likely conditions going forward. Investors should also inspect strategy reactivity, discretion and implementation, and exercise caution before selecting an approach that doesn't incorporate a sense of valuation.

The prospect that reflexively defensive strategies could create market-reinforcing feedback loops remains highly relevant. However, regardless of whether we are approaching the next U.S. market inflection point, investors should ensure they are fully informed on both the merits and the risks of such defensive strategies. It wouldn't be the first time that a class of strategies grew popular enough to distort its own effectiveness.

Seth Weingram is a senior vice president at Acadian Asset Management in Boston.