When Volatility Strikes, Add . . . Equity?

Bonds are the way to go to reduce risk, right?
Maybe not.

Investors are worried about the market forecasts they’re seeing these days and whether they can realistically meet their objectives. With the likelihood of higher volatility ahead, they face de-risking their portfolios using rather dated approaches.
There might be a better way: Add equity.

THE STATE OF PLAY
When investors look to the horizon today and anticipate increased uncertainty, they see numerous sources of major risk, including:

• More frequent volatility spikes: In the eight years prior to the 2008-2009 global financial crisis, a one-day move of five points or more on the VIX Index that gauges volatility occurred only five times. Post-crisis, such a spike has occurred 48 times.
• A prolonged business cycle: The U.S. business cycle has been seesawing between expansion and slowdown for over a decade since the end of the financial crisis. Although recession fears have ebbed for the moment, several known catalysts for a relapse remain. Hoping for the best, but planning for other scenarios, is sensible given a base case of muted returns.
• International trade conflict: Global trade tensions, and their knock-on effects of global supply chain recalibration and redistribution, have rocked global growth numbers. The U.S.-China dispute will likely take years to resolve. The “one world, two systems” model — capitalism on one side, statism on the other — will grow and evolve in a detrimental way.
• Uncertain central bank policies: Technology has a massive deflationary effect, which consumers love but makes central banks’ monetary policy targets difficult to achieve. Most central banks target inflation. If they can’t stimulate inflation to the appropriate level, how do they remain relevant? What is that new policy model behind their actions? There currently exists no macroeconomic theory that is consistent with today’s data. If we don’t know what to do from a monetary policy perspective, it has implications for volatility.
• More volatility selling: The microstructure of the market has changed materially, and thanks to algorithmic trading volatility selling has become more popular since the global financial crisis. That has contributed to more downside volatility, with much more likely to come.

RISK-ON OR RISK-OFF: A FALSE CHOICE?
Investors who rely on risk-on or risk-off views to determine how they might adjust their strategies could be in for a bumpy ride if the expected increase in volatility continues. This is especially true given the unpredictable nature of volatility that may lead investors to be too reactionary and close the stable door after the horse has bolted.

Is there a more effective way to handle market volatility while potentially providing much needed alpha to help close an anticipated returns gap? Can this be done without constant rejiggering and worrying about timing?

We believe there is. Low volatility equities have historically helped investors looking to jointly de-risk and improve returns. Surveying the performance of low volatility across the business cycle, we see that stocks in the lowest 20% of the Russell 1000 when measured by their volatility have indeed outperformed over the entire period; and they have done so with 35% less realized risk. Because of their favorable up-down market capture spreads, a well-calibrated low volatility strategy can stay close to the market while it’s trending higher, but avoid full participation in down markets.

Compounding this effect over time can therefore lead to improved risk adjusted returns, not only through a reduction in risk, but also through an improvement in return. This suggests that low volatility can simultaneously strengthen and de-risk a core equity portfolio so investors gain exposure to compensated risks within the equity market.

LOW-VOLATILITY EQUITY: DE-RISKING NOT SACRIFICING
For decades, U.S. and European institutional investors have been de-risking their portfolios by shifting from equities into fixed income or alternatives. Fixed income can always reduce risk, but the relative cost of doing so varies with interest rates and equity valuations. Hedge funds offer the promise of equity-like returns without the equity risk, and private equity offers much higher return potential, but with significant liquidity constraints. Low-volatility equities are a third option for investors to consider because they offer a means to reduce risk without necessarily sacrificing returns from equity allocations. In other words, investors can actually get paid for reducing their risk.

EXHIBIT 1: LOW-VOLATILITY EQUITIES ACROSS BUSINESS CYCLES
In slowdowns and contraction, low volatility equities have outperformed versus the broad market. Gold bars are for emphasis.

Source: For illustrative purposes only. Northern Trust Asset Management, Bloomberg. Entire period: 1978 to June 2019. Data as of June 30, 2019. Note: Russell 3000 Index data is shown. Factor returns are excess returns of the top factor quintile of the Russell 3000. Geometric averages used for entire period. For regime analysis, annual averages are displayed. Please see important information on hypothetical returns by reading When Volatility Strikes, Add . . . Equity? on pointofview.northerntrust.com. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transactions costs or expenses. It is not possible to invest directly in an index.

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By Northern Trust Asset Management
Michael Hunstad, Ph.D., Head of Quantitative Strategies

This blog is based on Northern Trust Asset Management’s Special Report: The New Way to De-Risk in Institutional Investor. Click here for the full report and here to watch related videos.
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