The current low-yield environment in Europe is focusing the investor’s attention on equities. Since rates are expected to first stabilise at low levels before starting to gradually rise, the expected return on bonds – be they government or corporate bonds – is fairly low.
However, notwithstanding the higher expected return on the equity markets, the risk profile of these markets is obviously significantly different to that of the bond markets. As equity-market volatility is much higher than volatility in most of the credit markets, this paper presents a new approach to investing in stocks, with the focus on reducing the risk, especially when compared to standard equity investments. The demand for defensive equity strategies was also spurred by the negative performance of the equity markets following the 2008 financial crisis.
The approach presented here combines the so-called low-risk anomaly with a quality approach. While the first concept is based mainly on historical market data, the quality approach uses forward-looking, fundamental company analysis. The purpose of the combined methodology is to create a portfolio with a lower beta than the broad equity market while matching its return via the creation of a positive alpha. As such, the portfolio will significantly deviate from the commonly used cap-weighted stock indices.
The rest of this paper is organised as follows. Section 1 assesses some undesirable characteristics of standard equity indices. Section 2 describes the low-risk anomaly. Section 3 decomposes the quality approach and section 4 reports the combination of both methodologies. Section 5 concludes.