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Is your “defensive” index true to design?

By: Catherine Yoshimoto, Senior Index Product Manager

Lately, as interest in passive investing and smart beta has grown, indexes that provide exposure to specific attributes—such as low-volatility or high-quality stocks—have been in vogue. However, if a given market cap-weighted index is not designed to provide exposure to specific characteristics it is difficult to justify using it to track such exposures. With the plethora of indexes available, it’s important for users to understand the ‘identity’ of their index.

Identify the goal. Selecting an index with a methodology that is aligned with the user’s goal is more suitable than selecting a broad market index and arguing its potential ability to meet the goal, since results may vary depending on the market. For those seeking a defensive small cap index—a combination of high-quality and low-volatility small company stocks—a compelling index is available using the Russell 2000® Index (R2) as the starting universe. The resulting Russell 2000® Defensive Index® (R2DF) has historically exhibited higher risk-adjusted returns—true to its design—focusing on higher quality or lower volatility small-cap stocks. The R2DF can be used as the basis for an index tracking fund seeking to capture defensive small-cap equity exposure or as a performance benchmark for actively managed funds.

Evaluate the index. In addition to differences between the conventional R2 and R2DF indexes, such as sector deviations, the R2DF exhibits risk-factor characteristics that are undeniably defensive in nature. Risk models such as those developed by Axioma,1 a risk analysis company, are frequently used by investors for portfolio analysis beyond routine determination of aggregate sector or fundamental characteristics. Three of the Axioma “style” risk factors2 can be associated with the Russell Stability Indexes methodology used to construct the R2DF. These are displayed in the chart below.

  • Return-on-Equity: R2DF contains companies with higher return-on-equity (ROE) relative to the R2 over our sample period. Since the R2DF methodology uses return-on-assets (ROA) as one of the measures of quality, it generally included a greater number of higher ROE companies relative to the R2.
  • Leverage: The R2DF methodology uses total debt/equity as the measure of company leverage. We observe that, relative to the R2, the R2DF included stocks with less leverage over most of the time period. The exception was during the March 2000 to June 2002 time period, which may reflect the types of companies included in the R2DF during the time period immediately preceding the tech sell-off in the early 2000s.
  • Volatility: Volatility is the companion to the quality component of the R2DF methodology and is defined by FTSE Russell as the average of the 52-week and 60-month price volatility of a stock. Here we can observe that, over our sample period, the R2DF included stocks that were less volatile than the broader R2, as demonstrated by the R2DF’s consistent negative risk factor exposure to Volatility.

For insight on the analysis of the Russell 2000 Defensive Index performance, characteristics and factors compared to the Russell 2000 Index, read the full paper, Small cap defensive: Oxymoron, or simply overlooked?.


Source: FTSE Russell. Data as at December 31, 2014. Past performance is no guarantee of future returns.
The inception date of the Russell 2000® Defensive Index is February 3, 2011. The inception date of the Russell 2000® Index is January 1, 1984. Returns provided for each Russell Index may include data for periods prior to when each Russell Index was in live production. Hypothetical historical returns for these Russell indexes prior to the live production date are calculated using the same Russell methodology; however, application to the performance calculation may vary due to data sources, corporate actions and the availability of historical data with respect to certain securities.

 

[1] For this analysis, we use the U.S. Fundamental Medium Horizon (AFMH) risk model developed by Axioma. The Axioma risk model is used to measure the various relative risks of a portfolio, and attempts to estimate the future volatility of the portfolio based on its exposures to the risk factors as determined from holdings. The AFMH is used to examine the historical benchmark-relative risk exposures of the small cap R2DF for the time period June 1996 through December 2014. The benchmark is the R2.

[2] Axioma uses the word “style” generically, to refer to a collection of several risk factors. These included Value and Growth, but also include a number of others.

 

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