The Rise of Defensive Portfolio Construction

October 2024

The number of US State pension plans including defensive alternatives within their strategic asset allocation has more than doubled over the past five years, with assets invested growing at 30% per annum to reach a record high of $57bn¹ at the end of 2022. Using detailed performance data available from March 2017 we find that the performance impact has been striking, as plans with a defensive asset allocation bucket have generated the same return as their peers but with an almost 20% reduction in portfolio volatility. While the approach has historically been successful, when we analyze portfolio holdings we believe investors can still do more. In this article we investigate the asset allocation evolution amongst the largest US investors and look in detail at how portfolio reallocations have increased resilience in periods of market stress.

The ever-increasing need for a balanced investment portfolio

The turbulence of the 2020 Covid crisis followed by the historically poor performance of major asset classes in 2022 is forcing investors to add resilience to their portfolios. As diversification between traditional asset classes breaks down and forward-looking return expectations shrink, many are looking to alternative investments. Investors have overwhelmingly turned to private markets for growth, at the expense of a lack of diversification in stress. As a result, there is a need for asset classes that that can effectively mitigate portfolio risk. In response we are seeing significant growth in allocations to alternative investment strategies such as trend-following and tail risk hedging that are explicitly designed to diversify and protect portfolios if traditional asset classes underperform. (Fig. 1)

From being a relatively niche investment area as little as five years ago, the use of defensive portfolio construction (“DPC”) has grown steadily amongst US pensions, increasing from just $10bn assets invested by the top 100 plans in early 2017, to $57bn at the end of 2022¹. The growth has come from both larger allocations within each plan as well as from new users – the number of plans mentioning a defensive allocation has grown from just six in 2017 to 15 currently. Amongst the group, the average defensive holding is meaningful, now at 10% of plan assets under management.

Under the hood – investor motivation and popular defensive investment styles

Although many investors are now tilting their portfolios defensively, allocations vary widely. Some are simply using long-dated Treasuries as a portfolio stabilizer, others are carving out the most diversifying parts of a traditional hedge fund allocation, whilst the most focused plans are allocating to explicit protection strategies. The motivation for adding defensive assets also differs across investors. Some take a broad approach, for example using a range of diversifying assets to target long-term return generation while reducing portfolio volatility. Others are more specific, focused on hedging tail risk to mitigate portfolio losses in severe equity drawdowns.

Analyzing portfolio holdings, we find that investors are overwhelmingly turning to trend-following, with managed futures strategies representing almost half of all defensive allocations. Macro hedge funds are the next largest, followed by multi-strategy funds and alternative risk premia.  Tail risk hedging allocations are also present with smaller nominal allocations, but these strategies typically only require a small investment to protect a significant part of the portfolio. (See Fig. 2)

Does it work? across top US state pensions¹

The key question is whether building a more defensive portfolio is improving investment returns. Historical performance analysis suggests it is – while the average top 100 US state pension plan lost 5%¹ in the 2021-22 fiscal year, those with a defensive allocation ended almost flat. Focusing in more detail on quarterly returns shows that plans with a defensive bucket have outperformed their peers in every negative quarter since 2017, with drawdowns reduced by almost one third on average. We have performance data running from March 2017 to September 2023 and find that plans with defensive allocations achieved the same return as their peers over the period but with a meaningful 17%¹ reduction in portfolio volatility. Bear in mind that these performance improvements came in a period of well above-average equity returns, with S&P 500 performance over the period in the top 30% of outcomes since 1927. We would argue that the benefit of a defensive allocation will be even more pronounced in the future if market returns normalize.

What next?

Our analysis suggests that taking a defensive approach to portfolio construction is helping plan performance, but based on the allocations being made, we believe investors can do more. To illustrate our point, we show performance of the most popular defensive strategy styles in four significant stress periods since the 2007-2008 Global Financial Crisis.

We make three key observations from the data:

1. In every stress period at least one strategy delivered a negative return and no strategy returned positively in every downturn, highlighting that there is no panacea. Given the variation in performance, arguably investors are too concentrated in trend-following, particularly important given its cyclical equity correlation.
2. Some strategies delivered negative returns in all our selected stress periods, specifically Multi-Strategy, Relative Value and Fund-of-Funds. While these strategies play an important role in generating returns over the cycle and funding the more protective allocations, their muted stress performance highlights the potential for ‘line-item risk’ and suggests that investors need to measure the effectiveness of a defensive allocation at an aggregate level.
3. Finally, we note that tail risk hedging strategies clearly offer the most convexity in stress, and as such should arguably form a more significant part of a defensive allocation than is currently observed.

In summary, and as always, we believe diversification is the key – here we believe investors should be careful with investments that retain some stress equity beta, and allocate across a range of different strategies to strive to ensure the portfolio is protected in different types of market downturn. Recent academic research may help investors find the right balance – an article published by Adlard and Leake demonstrates how alternative investment portfolios can be constructed to target specific equity correlation levels, and provides a framework for quantifying the risk/return trade-off associated with defensive assets[2].

An underappreciated benefit – defensives as a source of portfolio liquidity in stress

A less commonly mentioned property of defensive alternatives is that they tend to favour strategies trading futures and options which can offer high liquidity. As such, any gains can be quickly monetized to redeploy elsewhere in the portfolio. With many investors currently heavily overweight holdings in illiquid private markets, other parts of the portfolio are having to work harder to provide portfolio liquidity – defensives can offer an ideal combination of both high liquidity and potential for positive performance in market stress.

The important benefit of liquidity is certainly true in Capstone’s own experience – all our investors in defensive portfolios were able to liquidate at least some part of those holdings with us in the Covid period and were able to use the cash we returned for either offensive allocations or other portfolio liquidity needs.

Investors take a strong first step but can go further

Defensive portfolio allocations are becoming ever more popular amongst institutional investors. Those who have taken the positive first step have had the opportunity to reap the rewards over the past half a decade, but as we analyze the allocations they are making, we identify several areas where perhaps more can be done to maximize the benefit.

Defensive allocations have proved their worth even as equities hit high historic highs – if markets begin to stumble, the benefits are only likely to become more pronounced.

[1] Capstone, eVestment, Preqin.

[2] Adlard, T., and Leake, T. 2024. “Quantifying Portfolio Diversification Benefit via Return Indifference Curves.” The Journal of Portfolio Management.