- This paper proposes a framework for optimal defensive portfolio construction.
- Defensive strategies are generally characterized by a positive probability that they perform well in down equity markets.
- The key trade-off among equity equity-defensive strategies is their expected return versus their ability to diversify equity risk in down equity markets. In particular, the more reliable a strategy’s equity-hedging properties, the lower its expected return, and vice versa.
- In our model, the investor maximizes the portfolio’s unconditional expected return, subject to a constraint on its conditional equity beta.
- We show that the return to a defensive equity portfolio can be decomposed into a hedging component and a component that seeks to generate returns.
- We demonstrate that optimal defensive portfolios exhibit better return-defensiveness properties relative to the underlying strategies.
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