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What Is The Best Defensive Asset Class? (A Study)

Last Updated on 10 February, 2024 by Abrahamtolle

In the world of finance, understanding which assets provide the best defense in times of market turmoil is a crucial aspect of investment strategy. In this comprehensive exploration, we delve into the intricacies of “The Best Defensive Asset Class,” analyzing the methodology, key findings, and implications for investors seeking refuge in the complex landscape of financial markets.

Methodology Used In The Study

The study is based on an article published by the insightful website AllocateSmartly, a website we recommend reading. As mentioned, the study is called The Best Defensive asset class.

The methodology spans over 50 years to evaluate the performance of major asset classes during months when the S&P 500 experienced a decline.

The selected asset classes include Aggregate US bonds (AGG), Intermediate-term US Treasuries (IEF), Short-term US Treasuries (BIL), Inflation-protected US Treasuries (TIP), US corporate bonds (LQD), Diversified commodities (DBC), Gold (GLD), and the US dollar index (UUP).

Key Findings of The Study

Let’s now take a look at the major findings of this study.

1. Major Defensive Asset Classes

The analysis begins by assessing how these asset classes performed during months of S&P 500 decline.

The key takeaway is that gold (GLD) emerged as the singular outperformer, surpassing short-term US Treasuries (BIL) over the entire 50+ year period, albeit with some notable setbacks along the way.

The original study notes, “Only one asset class, gold (GLD), outperformed short-term US Treasuries (BIL) over the entire 50+ year test (and that was only after some big losses along the way).”

Interestingly, all defensive asset classes proved unreliable diversifiers at various points during the extensive test period. The research paper states, “All defensive asset classes were unreliable diversifiers at various points in our test.”

2. Bonds in Falling Markets

Focusing specifically on bond asset classes, the performance of longer-duration US Treasuries (AGG, IEF, and TIP) exhibited varying degrees of success until the turn of the century, after which returns became more consistently positive.

The original research paper notes, “The performance of longer-duration US Treasuries (AGG, IEF, and TIP) was middling up until roughly the turn of the century.

Short-term US Treasuries (BIL) proved less impacted by market changes and experienced fewer drawdowns. According to the study, “BIL returns have fallen over time as coupon yields have also fallen but would have never experienced a significant drawdown.”

US corporate bonds (LQD), on the other hand, consistently performed the poorest, aligning with their strong positive correlation with stock returns. The research paper states, “US corporate bonds have been the worst-performing bond asset class during falling stock markets.”

3. Gold and Commodities in Falling Markets

Zooming in on gold (GLD) and diversified commodities (DBC), gold stood out as the only major defensive asset class outperforming short-term US Treasuries over the last 50+ years during market downturns.

According to the original research paper, “As previously mentioned, gold is the only major defensive asset class that’s outperformed short-term US Treasuries (BIL) over the last 50+ years when the market has fallen.

Diversified commodities (DBC) provided diversification opportunities until 2008, after which they essentially behaved like a risk asset, falling consistently when the stock market declined.

The study notes, “Diversified commodities (DBC) would have been a better diversifier until 2008. Since that point, DBC has essentially acted like a risk asset, consistently falling in months when the stock market fell.”

4. US Dollar in Falling Markets

Analyzing the US Dollar Index (UUP) during months of S&P 500 decline revealed an interesting trend. While a third-party analysis based on a limited timeframe suggested the US dollar consistently rose during stock market downturns, the longer-term analysis presented a more mixed picture. The original research paper states, “Over the long-term, results have been mixed.”

In short, the US dollar is the most unreliable diversifier of any major defensive asset class included in this analysis. According to the research paper, “In short, the US dollar is the most unreliable diversifier of any major defensive asset class included in this analysis.

5. Defensive Exposure with Tactical Asset Allocation (TAA)

The exploration further delves into the effectiveness of tactical asset allocation (TAA) strategies in investing in defensive assets. The research paper states, “These results are much more consistently positive than in our previous tests. All asset classes except the US dollar (UUP) have outperformed short-term US Treasuries (BIL) over the entire test.

The juxtaposition of these results came as a surprise to the authors of the research paper. They note, “The juxtaposition of these results came as a surprise to us. It says that the effectiveness of TAA hasn’t just been in predicting when risk assets would fall, but also, when defensive assets would rise.

6. Bonds as Defensive Assets

A word of caution is raised regarding the use of bonds as catch-all defensive assets. The research paper warns, “While that approach worked well historically, it’s failed miserably this year, with both risk assets and bonds falling in unison (read more and more).

Conclusion

In conclusion, the study by allocateSmartly provides a nuanced perspective on defensive asset classes.

It emphasizes that no single major asset class guarantees foolproof defensive exposure, perhaps as expected. Long-duration bonds, short-duration bonds, gold, commodities, and the US dollar all come with their set of risks and opportunities.

The key takeaway for investors is that defensive asset classes should be managed actively, employing trend-following, momentum, or other quantitative approaches. In the financial landscape, adaptability and a nuanced understanding of each asset class are paramount for effective defensive strategies.

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