The nature of volatility has changed, and investors need to adjust

By BOB PARISE/Northern Trust Asset Management

Key Points: 

• A new era of volatility means investors must search for ways to achieve their portfolio objectives.
• The components of volatility have changed, demanding different strategies to create alpha.
• In this down market, investors have an opportunity to rebuild with a more resilient core.
• To learn more about low volatility equities, visit our website.

There have been 56 volatility shocks since the 2008 global financial crisis, defined as when the VIX Index volatility measure increased more than five points in a day. In the seven years previous, largely due to the bursting of the Tech Bubble, that happened five times. Investors are in a new era of volatility that leaves them searching for new ways to achieve their portfolio objectives.

While we will likely recover from the market volatility of the moment, we believe that the trend of more extreme swings is here to stay. Equities are increasingly sensitive to changes in interest rates and economic growth. Computer trading programs are ready to quickly unload equities when markets shiver. And “momentum- or trend-driven” investment strategies that drive volatility are increasingly popular.

 

In an environment marked by rapid market swings, investors looking to consistently outperform will have to increase their emphasis on downside protection while maintaining their upside participation.

Breaking Down Volatility for the Desired Outcome

The secret to finding alpha in this sporadic — and sometimes violent —volatility is in breaking down the volatility itself. Our research analysts have taken a closer look under the hood of these bouts of volatility, and have found there is a very clear trend that market volatility is becoming more asymmetric in nature. Meaning that when markets go down, they are doing so much more rapidly than the corresponding rebound. This is known as volatility asymmetry.

The ratio of volatility in down markets versus up markets, an expression of asymmetry, has been trending upward over the past 30 years. Simply put, markets are declining more rapidly than when they move up. Granted, investors have enjoyed some years of outsized equity returns that has softened the blow of these volatility spikes. But we think the coming years hold below average returns across asset classes, based on our five-year outlook. This leads investors to reassess their portfolios’ readiness to meet objectives in this new volatility paradigm.

Exhibit 1: the volatility gap in up and down markets is growing

The ratio of volatility in down markets versus up markets, an expression of asymmetry, has been trending upward over the past 30 years, causing more extreme volatility swings.

Source Source: Northern Trust Asset Management, FactSet. Russell 1000 Index. Data from 1/1/1990 to 3/13/2020. Chart shows the realized monthly volatility in up and down markets, as well as the ratio. Monthly volatilities calculated using daily return data in each month. Values averaged across selected time horizons. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.

Building a Portfolio Core for Resilience, Performance and Consistency 

While down markets generally offer very little to get excited about, they do offer the opportunity to be more nimble and make changes to the portfolio. Investors should take this opportunity to make a few key strategic changes to their portfolios with a more resilient equity core. This new core should fit the way markets behave in this new environment to create alpha and help them reach their objectives. Low volatility equity strategies provide that strong foundation.

 

The companies that underlie a lot of low volatility equity strategies tend to be mature firms with steady profits and well-established brands, often associated with the consumer staples, utilities and health care sectors. They may be more defensive in nature, performing well during recessions or in market downturns, or they may pay dividends to soften the blow when stock prices fall.

 

However, low volatility equity investing isn’t just about reducing risk to mitigate the effects of large drawdowns that chip away at portfolio returns over time. It’s about outperforming the broad market by exploiting the uneven downside and upside volatility explained above.

 

In other words, volatility asymmetry also translates into return asymmetry in a low volatility equity strategy. This means that, historically, low volatility equities have outperformed the broad market because they limit losses on the downside and gain more on the upside. Exhibit 2 shows this pattern. By compounding this difference in up and down market capture over time, low volatility equity strategies are able to not only reduce risk but also enhance returns, in up and down markets.

Exhibit 2: the right risk profile is needed to generate alpha

Continuing to achieve portfolio objectives in this environment will require a greater use of investment strategies with a similar risk and return profile.

Turning Low Volatility into Alpha

To achieve alpha, a low volatility equity strategy must do more than simply adopt the inherent advantages of low volatility equities. In creating low volatility strategies, our philosophy is to focus on risks that we are getting paid to take. That’s why the strategy is sector and region neutral. We have found that taking active bets on sectors and regions are risks that historically are not compensated with higher performance, and in fact those bets tend to dilute performance of low volatility equities. We also have found the further screening low volatility for quality companies — those strong cash flows, profitability and management efficiency — can aid performance through the cycle.

 

This new volatility environment, where markets change risk posture on a dime, appears here to stay. We continue to see periods of market calm followed by volatility storms like we are experiencing now. Traditional active and passive large cap equity strategies are not equipped to deliver alpha during such volatility. We believe the current volatility regime will continue to provide a tailwind to portfolios with lower volatility, higher quality equities at the core.

>To learn more about low volatility equities, see Northern Trust's webinar on demand.

>Read Northern Trust's disclosure.  

 

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