How to navigate the new norm of volatility

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. In the ten years before the crisis, a volatility spike — which we define as a one-day increase of at least five points in the VIX Index — occurred only eight times. In the following ten years, the number of volatility spikes jumped more than five times.

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 historically low interest rates. And while equities have performed well over the past decade even with volatility spikes, we expect economic growth and stock returns to moderate, permitting less room for error.

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 low volatility equity strategy as a core equity allocation may help not only to manage risk, but increase the chances of outperformance.

Facing the new volatility norm in a new way

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. With low long-term bond yields, a higher bond allocation increases the risk of lower returns even more.

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 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. Low volatility equities gained 84% of the average monthly market positive return and lost just 68% of the decline from 2010 to 2020. This rachet effect — gaining more than losing — makes the strategy’s outperformance more likely in the long term.

Dampening portfolio volatility, and performing, with a strong core

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. 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, hold stocks that best match the ideal low volatility equity profile, and blend in high quality companies. 

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.

So investors struggling to navigate this new norm of volatility may hold more options than they think. A well-designed low volatility equity strategy precisely invests in stocks with the most effective risk/reward profile and avoids 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 achieve their most important objectives.

Learn more about navigating more frequent and extreme volatility by downloading Northern Trust Asset Management’s e-book Navigating Extended Periods of Market Volatility.

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