Less Room for Error
Investors must navigate an increasing number of sudden and extreme moments of volatility in the equity market, called volatility spikes. Investors experienced some of these spikes throughout the COVID-19 pandemic, but this volatility pattern emerged after the 2008 Global Financial Crisis and has persisted since.
To address this new risk, the traditional method of “de-risking,” or lowering portfolio risk, by boosting the bond allocation may worsen performance because of interest rate volatility. Further, we expect the stock volatility of 2022 to persist as the economy struggles, permitting little room for error.
So investors face falling short of their objectives without a strategy suited to both soften the blow when stocks falter and participate in gains during rallies. A well-designed equity strategy as a core equity allocation may help not only to manage risk, but increase the chances of outperformance over the long term.
The low volatility factor targets companies with less volatile cash flows.
The New Norm: Volatility Spikes
The nature of volatility may have changed for good since the 2008 crisis, when the U.S. banking and financial system faced failure with a surge in mortgage defaults. In the 10 years before the crisis, a volatility spike — which we define as a one-day increase of at least five points in the — occurred only eight times. In the following 10 years, the number of volatility spikes jumped more than five times.
The Cboe Volatility Index (VIX Index) measures investors' consensus view of future expected volatility of the stock market as represented by the S&P 500 Index.
EXHIBIT 1: A Volatility Inflection Point
Volatility spikes, when the VIX Index jumps at least five points in a day, have surged in frequency.
What's Driving Volatility Spikes?
Possible drivers of volatility spikes include:
Non-financial events: The COVID-19 pandemic showed how non-financial events can trigger ongoing volatility. Political, economic and military tension among China, Europe and the U.S. — or even climate change — will also likely take unpredictable paths.
Volatility trading: Trading strategies designed to profit from changes in volatility have gained popularity thanks to computers that can react to subtle market changes within seconds. All volatility strategies are similar, with a tendency to move the same direction during volatility shocks. The $1.5 trillion invested these strategies give them enough heft to exacerbate the magnitude of market swings.1
Volatility spikes have produced another alarming pattern — an increasingly asymmetrical volatility gap between down and up equity moves. This means that volatility when equities fall has surged relative to volatility when equities rise. In the 1990s, the volatility (standard deviation) of negative monthly returns of U.S. large-cap companies was 14% while the volatility of positive monthly returns was 11.9%, a of 1.17. In the 2010s, that ratio jumped to 1.46. Down markets have become increasingly less predictable relative up markets, forcing investors to reassess the readiness of their portfolios against losses.
The ratio is calculated as downside volatility, or the volatility of negative monthly returns, divided by upside volatility, or the volatility of positive monthly returns. When higher than 1, the ratio indicates that negative returns of an asset are less predictable (more volatile) than positive returns. When the ratio is less than 1, it indicates that negative returns are more predictable (less volatile) then positive returns.
EXHIBIT 2: The Growing Volatility Gap
The ratio of volatility in versus , an expression of asymmetry, has been trending upward over the past 30 years, causing more extreme volatility swings.
An up market is when a market benchmark has a positive return in a month.
A down market is when a market benchmark has a negative return in a month.
A New Way to Solve for Volatility
Investors have typically prepared for expected higher volatility by increasing their bond allocation and reducing their equity holdings. This may reduce risk, but at a cost of reducing returns as well. Adding 10% to the bond allocation from an initial 60% stock/40% bond portfolio to a 50%/50% portfolio from 2000 to 2021 would have reduced volatility but also decreased return.2 With persistent low yields, a higher bond allocation increases the risk of lower returns even more.
“That’s the classic knee-jerk reaction to lowering risk,” said Michael Hunstad, head of quantitative strategies for Northern Trust Asset Management. “But in today’s market, investors are very cautious about this given where government and corporate bond yields are in the U.S. and globally .”
Adding bonds to quell portfolios during volatile markets (risk-off) or increasing stock holdings to take advantage of low volatility (risk-on) creates a false choice. Low volatility equity strategies, which invest in companies with below-average volatility in cash flows and stock prices, provide another option that diminishes the relevance of risk-on/risk-off thinking. Low volatility equity strategies historically have limited losses during volatility surges and participated in gains when equities rally, potentially reducing portfolio risk and while maintaining equity performance.
However, investors will likely fall short of their goal to outperform by investing in a strategy that only softens the up and down swings of the equity market. Well-designed low volatility equity strategies play well into the asymmetrical nature of volatility mentioned above.
The strategies historically have captured a larger portion of equity market gains than they lose in market downturns. On average, low volatility equities captured 85% of the average monthly market positive return and lost just 70% of the decline from 2010 to 2022 (see Exhibit 3). This rachet effect — gaining more than losing — makes the strategy’s outperformance more likely in the long-term.
EXHIBIT 3: The Right Risk Profile Is Needed to Generate Alpha
Continuing to achieve portfolio objectives in this environment may require a greater use of investment strategies with a similar risk and return profile.
Low Volatility Equity Strategy Design Matters
Low volatility equities have established a long history of outperforming higher risk securities from an academic perspective, possibly because investors tend to overpay for higher risk securities to boost performance.3 But how you define and execute these strategies makes the difference between average performance and outperformance.
Effective strategies should:
Target the most asymmetrical low volatility equities. Investors can hone in on those low volatility equities with a “high spread” between and , increasing the chance of outperformance.
Take risks that pay. Strategies should hold stocks that best match the ideal low volatility equity profile, which has proven to compensate investors over time. on sectors, regions or currencies have not proven to pay off.
Blend in high quality companies. companies generate high returns on capital and strong profits while keeping debt low. “By adding a quality dimension, you meld those ideas — low price volatility, good profitability, cash flow, balance sheet, and so on — to come up with what we believe to be the best investments,” Hunstad said.
Active risk is the degree to which an investment manager's investments and returns differ from the benchmark in the manager's effort to beat the benchmark.
In months when the market rose, up-market capture represents how much (percentage) of that market gain an asset historically captured on average. For example, if the broad stock market returned 2% in a month, a single stock that returned 1% had a 50% up-market capture.
The quality factor targets companies with efficient management, profitability, and strong cash flows.
In months when the market fell, down-market capture represents how much (percentage) of that market decline an asset historically captured on average. For example, if the broad stock market lost 2% in a month, a single stock with a 1% loss had a 50% down-market capture.
A Core to Dampen Volatility and Perform
A well-designed low volatility equity strategy provides a portfolio construction tool to better navigate today’s volatility and potentially drive outperformance. The strategy allows investors to build their portfolios toward a range of expected outcomes, depending on their risk preferences or return requirements.
Going back to the 60% equity/40% bond portfolio, if investors replaced their 60% equity allocation completely with low volatility equity then risk falls significantly but the portfolio return increases, based on U.S. stock and bond returns from 2000 to 2021.4 But what if you feel comfortable with the your portfolio risk now? Then you can increase the low volatility equity strategy allocation to where portfolio volatility returns to the same level as the initial 60/40 portfolio, but with a higher equity allocation and return.
“If you look at the changes we’ve made to meet this increasing volatility, all you have really done is shift a portfolio’s allocation toward low volatility, increase the equity allocation overall, and kept the risk the same,” Hunstad said. “A lot of investors see the lack of value in the bond market, but equities have a lot of potential upside. We like the equity market, but we want investors to get paid for that risk they take.”
Navigating Volatility with Success
Investors struggling to navigate this new norm of volatility may hold more options than they think. We believe that a well-designed low volatility equity strategy aims to invest in stocks with the most effective risk/reward profiles and avoid taking risks that lead to unintended outcomes. In the long run, this strategy as the equity core in a diverse portfolio can help investors not only survive through the new volatility, but potentially achieve their most important objectives.
1Vineer Bhansali & Larry Harris (2018) Everybody’s Doing It: Short Volatility
2 Strategies and Shadow Financial Insurers, Financial Analysts Journal, 74:2, 12-23, DOI: 10.2469/faj.v74.n2.62 In from 2000 to 2021, a portfolio of 60% equities represented by the Russell 1000 Index and 40% bonds represented by the Bloomberg U.S. Aggregate Bond Index returned 6.91% with a standard deviation of 9.17%. A 50% equity/50% bond portfolio returned 6.63% with standard deviation of 7.71% during the same time period
3 The anomaly was first documented by Friend and Blume (1970), and motivated Jensen, Black, and Scholes (1972) to challenge the assumptions of the renowned Capital Asset Pricing Model (CAPM). Haugen and Heins (1975) explored the topic thoroughly using data from 1926 to 1971 and concluded “over the long run stock portfolios with lesser variance in monthly returns have experienced greater average returns than their ‘riskier’ counterparts.” Behavioral biases examined by Kumar, 2009, and Bali, Cakici and Whitelaw, 2011.
4Low volatility equities are represented by the Northern Trust Quality Low Volatility index. Please see important information on Hypothetical Returns and past performance at the end of this presentation. The case study presented is intended to illustrate products and services available at Northern Trust. They do not necessarily represent experiences of other clients nor do they indicate future performance. Individual results may vary. Data from January 1, 2000 to December 31, 2021.
When Volatility Strikes, Add . . . Equities?
When volatility strikes, investors understandably may boost their bond allocation to arm their portfolios for more risk to come. But they have another choice: Add to the equity allocation with a low volatility equity strategy. A portfolio core of a well-designed low volatility equity strategy — taking advantage of the asymmetrical up-down patterns of the market — may reduce portfolio risk while enhancing performance.
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