Thinking outside the style box

Defensive equity income strategies can help investors weather the challenges of sometimes severe market swings

Mar 22, 2018 @ 10:17 am

By Mike LaBella

The popular "style box" developed by Morningstar Inc. goes back to 1992. Entire generations of mutual fund managers, financial advisers and investors have never been without the concept.

An intuitive framework for equity investing, the style box construct splits the opportunity set into size (large, mid and small) and value/growth segments. Investors and finance professionals rely on these boxes to balance risk exposure and gain diversification in equity portfolios.

Yet the reliance on style boxes has not always gone smoothly. During periods of market turmoil, seemingly diversified portfolios often have failed to live up to investors' expectations.

In the wake of the financial crisis of 2008, there has been a rapid rise in the popularity of factor-based smart beta strategies, which follow outcome-based approaches. Some investors have shied away from smart beta, unsure of how these approaches work and how to deploy them in their portfolios. However, smart beta strategies can be used within the intuitive style box framework, providing potentially better solutions to investment needs.

These strategies often are designed to capture stocks with fundamental characteristics that aren't captured in the style box, such as low volatility, dividend yield, quality and momentum, that can diversify and enhance traditional investing styles. One example is value investing.


Value premia have been proven to exist over time: Investors can earn alpha as mispriced stocks appreciate. Yet value investing poses emotional challenges. To successfully harvest that premia, value investors must be willing to stomach some discomfort stemming from:

Cyclicality. Value investing can go in and out of favor for prolonged periods. Investors must have a long-term view. Trying to tactically "time the market," to guess when a factor is most out of style and sell just then, can interrupt long-term growth realization.

Drawdowns. Ebbs and flows create opportunity, but when markets get overly pessimistic or optimistic on sectors or segments, it can lead to sharp drawdowns in value stocks.

Volatility. Value stocks may exhibit more volatility than the broader market because investors often disagree about the future potential for these "out of favor" stocks.

That's a lot to ask of the average retail investor. The challenge can be mitigated by allocating some of investors' value sleeve to defensive equity stocks that can exhibit similar, but potentially less volatile, return characteristics.


Defensive equity income strategies invest in consistently dividend-paying stocks with strong earnings and profitability. This approach seeks to avoid risky stocks by avoiding companies with higher short-term price and/or earnings volatility. Blending this conservative approach with traditional value strategies that invest in stocks with attractive prospects over longer time frames can help investors weather the short-term emotional challenges of sometimes severe market swings, thus allowing them to fully harvest the long-term value premia.

Defensive equity income strategies focus on high earnings yield (E/P) companies, which result in low overall price-to-earnings (P/E) ratios. This differs from traditional active and passive value funds, which tend to focus on low price-to-book (P/B) stocks.

Companies that defensive equity income strategies tilt toward tend to be in favor at very different times than securities targeted by value and growth funds. This results in different overall sector style exposures. It can lead to enhanced diversification, increased consistency of returns within both the value sleeve and portfolio, and reductions in risk.

What makes a defensive equity income strategy complementary to traditional value?

High income. Especially important in slow growth and low return environments, the dividend screen filters stocks that have and are projected to pay unusually high dividends.

Valuation. A key focus as valuations continue to swell, the strategy screens for companies that have the power and profitability to support solid, regular dividends.

Balanced return/risk profile. To reduce average drawdowns and provide more balanced upside and downside capture, the strategy considers profitability as well as historical and forward-looking volatility measures.

In these richly valued markets, that have begun to show a return to normal or higher volatility, investors should think beyond style boxes. Combining styles with smart beta strategies (such as defensive equity income) can help investors diversify and refine their equity portfolios — and achieve their long-term financial objectives.

(More: BlackRock takes aim at sacred cow to bring factors to the masses)

Mike LaBella is a portfolio manager at QS Investors, a subsidiary of Legg Mason.


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