Tom Goodwin, PhD, is Senior Research Director for Russell Indexes focusing on helping clients utilize Russell index tools to better understand capital market dynamics, more accurately measure market and portfolio performance, and gain efficient exposure to investment styles, market capitalizations or asset classes. In this email interview with SmartBrief, Mr. Goodwin discusses the difference between dynamic and defensive styles and how indexes are responding market changes.
Q: How do Russell’s Stability Index styles (Dynamic or Defensive) differ from the more traditional definition of style (Growth or Value)?
TG: Just like the markets, indexes are evolving. In 1984 Russell emerged as a leader in the creation of indexes with its introduction of the Russell 1000 U.S. large cap and Russell 2000 U.S. small cap indexes — transparent, rules-based indexes that accurately define the dimensions of U.S. equity market segments. These market cap weighted indexes were used as reliable benchmarks for evaluating investment manager performance. Russell then pioneered ‘style’ indexes with the launch of the Russell 1000 growth and value Indexes, which provided the basis for the widely used, two dimensional “style box.” These first style indexes grew out of the insights gained form Russell’s extensive manager research efforts and were based on basic growth/value metrics.
Now, through its deep research into market and investment manager behavior, Russell has rounded out its analysis to identify what it defines as a new dimension of style, which we call ‘stability.’ Stability looks at a broader range of factors to create a powerful set of descriptive variables, different from traditional growth/value style metrics. These variables include leverage, earnings variability, return on assets, and price volatility, which are divided into quality and volatility components. Stability scores — ranking stocks along the spectrum of quality and volatility — become the basis for ‘dynamic’ and ‘defensive’ indexes. Dynamic/defensive offer unique insight into stock performance, and add a new third dimension to the traditional style box.
Q: Tell me a bit about the background of the Russell Stability Indexes. Why were they constructed?
Going back to 1990, Russell Investments’ manager research analysts noticed that there were times in the market cycle when stocks with certain characteristics were either rewarded or punished, and importantly that this couldn’t be attributed to traditional capitalization or growth/value style measures. Managers who loaded up on stocks that were sensitive to the economic cycle would do poorly during a downturn and win during an upturn, regardless of whether the managers were classified as Growth or Value. The analysts began to think of those managers as ‘dynamic.’ Conversely, managers whose portfolios consisted of stocks that were less sensitive to the economic cycle would outperform during downturns. These managers were defined as ‘defensive.’
Extensive research into the characteristics of defensive and dynamic stocks revealed that they are distinguished by two factors: quality and volatility. Stocks classified as defensive tend to have high quality and low volatility measures. Dynamic stocks have relatively weaker accounting-based measures (quality) and higher volatility, and are pro-cyclical in their performance.
While low volatility indexes are quite popular at the moment, Russell alone has combined volatility and quality measures into a more comprehensive definition of risk creating two unique groups of stocks, the Defensive and Dynamic Indexes. The creation of an index for each side of the risk divide allows investors to better gauge investment portfolio positioning in risk-on and risk-off environments.
Q: How did Russell’s research regarding previous market events such as Asian Contagion, the Long-term Capital Management crisis and the Russian debt crisis affect the construction of the Russell Stability Indexes?
The mid-to-late 1990s were great for stock price appreciation. Although there were several interruptions for the so-called Asian Contagion, the Long-term Capital Management crisis and the Russian debt crisis, these issues were somewhat transitory, so we will focus in on some larger market drivers.
Tech bubble — By the end of the decade, investor euphoria around dynamic, internet-associated companies was red hot. Investors shunned stocks of companies in less exciting, defensive industries. It was a classic ‘risk-on’ environment. Both dynamic and growth styles were winners during this period, so it was difficult to distinguish between them. But when the tech bubble burst (2000-2002 period), the gap between value and growth stocks narrowed. The volatile stocks that led the market upward declined just as quickly. Defensive stocks were the clear winners. When the economy rebounded in 2003 the environment was back in a risk-on mode. Our analysts heard managers with defensive portfolios — both value and growth styles — complain about a “junk rally” where quality was being completely ignored. Dynamic stocks were winning.
The great recession — In 2008, all stocks suffered a free fall, but defensive stocks with low debt/equity ratios suffered far less than their dynamic counterparts — 2008 performance of the Russell 3000 Defensive Index was -28.9% for the year versus -46.3% for the Russell 3000 Dynamic Index. When the equity market turned in early 2009, Russell analysts noted that it mattered less what a manager’s position on the growth/value/cap dimensions were and much more where they were on the defensive/dynamic dimension. The 2009 performance of the Russell 3000 Dynamic Index was +41.1% versus 18.6% for the Russell 3000 Defensive Index. Dynamic stocks, and the managers who bought them, were the big winners.
Defensive investing is relatively low risk and tends to do best in risk-off, or defensive, environments, but will likely give up some of the upside in risk-on environments. Dynamic investing takes the other side of the defensive approach, fully capturing the upside in risk-on markets and suffering during downturns. The Stability Indexes have become powerful new institutional benchmarks for assessing the positioning and performance of portfolios.
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