Since the global financial crisis in 2008-2009, investors around the world have become more wary of equity-market volatility. Here in Canada, there are also country-specific risk factors to consider, based on our strong home bias in investing, the relatively small size of our market and its high sector concentrations. Canadian equities make up only about 3.5% of the world’s total stock-market capitalization. And, as we’ve seen lately, our high proportion of volatile resources stocks can amplify cyclical swings.
A defensive equity strategy aims to reduce volatility. As noted in a paper released last year by Russell Investments Canada Ltd., this type of strategy has a different objective than simply seeking to outperform the broad market or competing funds in the same category.
Authored by Adam Hornung, institutional investment strategist at Russell Canada, the paper says a defensive strategy attempts to limit severe losses during the worst-performing periods. However, Hornung adds, this investment approach has less upside potential in rising markets.
Investors often associate value investing with defensive investing. But the Russell Canada paper says defensive stocks are neither a sub-set of growth nor of value. Instead, they’re a distinct style on their own. For example, in the Russell Defensive Index of Canadian stocks, the holdings companies held in the index have some metrics associated with value and others with growth.
The link between defensive investing and value investing in Canada may vary considerably over shorter time periods. However, data compiled and analyzed by Russell show that having a long-term value bias in a portfolio may provide investors with a more defensive outcome.
A defensive investment approach to Canadian equities can entail multiple strategies:
Broad sector exposure:
More than two-thirds of the Canadian stock market, as measured by market capitalization, consists of financial services and resources stocks. Having broader sector exposure is one of the strategies of Russell Focused Canadian Equity Pool, which has a significant defensive orientation. “We have a deep underweight in financials,” says Thierry Vallée, a senior portfolio manager and head of Canadian equities at Russell Canada, “and we also have a decent underweight in energy.”
Sustainable dividends:
Dividend-paying companies can be ideal defensive holdings, depending on their other attributes. Favourable characteristics include strong balance sheets, sustainable earnings growth and management that deploys free cash flow wisely. To be avoided, says Russell, are companies that are highly leveraged, with low returns on equity and volatile earnings.
Blend of styles:
Though not strictly speaking defensive, style diversification can help smooth out market cycles, since value, growth and other stock-picking disciplines can be in or out of favour at different times. The strategy of Russell Focused Canadian Equity, which is a “large-cap blend” in the Morningstar Equity Style Box, involves employing multiple managers: Rondeau Capital Inc., whose style Russell describes as “defensive,” QV Investors Inc. with its “quality and value” discipline, and the more growth-oriented CGOV Asset Management. Each firm is responsible for contributing 25 to 30 of its best ideas.
Foreign holdings:
Along with their domestic stock selection, most retail fund managers will use non-Canadian holdings to diversify their Canadian stock portfolios and reduce risk. For that reason, it’s important for investors to realize that their Canadian stock funds won’t necessarily be purely Canadian.
By definition, funds in the Canadian Equity category may invest up to 10% of their assets in foreign securities. For funds in the Canadian Focused Equity category, up to 50% of the stock portfolio may be non-Canadian.
At Russell Canada, the U.S. component, to a maximum 10% weighting, is part of the strategy for Russell Focused Canadian Equity. Health-care and technology are two examples of U.S. sectors where there is vastly more choice for stock pickers than in Canada. “There are great businesses to be found in the U.S.,” says Vallée.
Cash reserves:
Finally, cash can be used as a defensive tool by active managers. Until recently, “over the last two to three years, it’s been a one-direction bull market,” Vallée says. “It’s been difficult for a stock picker, so the cash just built up.”
Conversely, after the Canadian market’s recent tumble, now would appear to be an opportunity for active managers — including those with defensive mandates — to deploy some of their low-yielding cash reserves.