Security Check for Equity Declines

Sharon Fay (pictured) and Kent Hargis

Protecting against stock-market declines is a top priority for many investors. But with lower-volatility stocks looking expensive today, will they get the job done if equities fall from new peaks?

As investors prepare for the next potential downturn, there’s been a meaningful shift over the past few years into lower-volatility stocks. That’s why they look so pricey today.

We have advocated holding stocks that can provide stability in turbulent markets as part of a balanced approach to equity investing. In our view, investors should consider owning a combination of return-seeking equity strategies that are typically somewhat riskier, along with risk-reducing portfolios that provide protection in a downturn. Our research suggests that this approach should yield more consistent returns. The precise prescription depends on an investor’s long-term goals and risk appetite.

But given the starting point today, will lower-risk equity strategies that are designed to provide some protection in down markets meet expectations? To answer this question, we decided to look to history for some guidance. We constructed a proprietary minimum-variance index of global stocks with lower-volatility characteristics from 1989 through today. These companies had less sensitivity to the economic cycle and their stocks were less volatile, with lower return correlations than the broad market.

Lower-Volatility Stocks Are Expensive…

At the end of April, the price/book value of the minimum-variance index was about 19% higher than the MSCI World Index. That’s an improvement from early 2009, when it was valued at 43% higher than the market. Yet it’s still more expensive than the 25-year average (Display).

 When markets were choppy, these stocks typically provided protection. Our research shows that in months when equities declined, the minimum-variance index outperformed the broad market 83% of the time.

…but Valuation Doesn’t Undermine Protection

What about valuation? To answer the question we’re facing today, we broke months down into periods when lower-volatility stocks were either more expensive or cheaper than the broader market.

There wasn’t much of a difference. Whether the minimum-variance index was cheaper or more expensive than the market, it still outperformed the broader index more than 80% of the time during a down month (Display). And even in the 20% of months when it didn’t outperform, low-volatility protection usually kicked in during the following months. When equity markets fell for three to six months, expensive low-volatility stocks actually did an even better job of mitigating the damage.

There’s a plausible explanation for this. Valuation isn’t necessarily correlated with the defensive elements that are embodied by lower-volatility stocks. And these companies are less sensitive to changes in growth and interest-rate expectations, which often trigger a short-term market decline.

Does It Always Work?

Certain conditions may create tougher challenges. For example, when markets expect rising interest rates without the accompanying economic growth, lower-volatility stocks probably won’t work as well as usual. In 1994, lower-volatility stocks underperformed in a down market. They continued to trail the benchmark over the following three months as the Fed raised interest rates more than investors had expected, threatening economic growth.

But that’s not where we are today. The Fed has made clear that interest rates will only rise if US economic growth prospects are improving. So history suggests that even though lower-volatility stocks are a bit pricier than usual, they will help shield portfolios if equity markets fall from their current peaks. And by taking an active approach, we think a portfolio can avoid stocks that are more vulnerable to a protracted rise in interest rates—which tend to function as proxies for bonds—and improve the chances of success in a downturn.

This blog was originally published on InstitutionalInvestor.com.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices, any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Sharon Fay is Head of Equities and Kent Hargis is Portfolio Manager of Low Volatility Equities services, both at AllianceBernstein (NYSE:AB).

Sharon Fay

Sharon E. Fay was named Head of AB Equities in July 2010. She is responsible for overseeing the portfolio management and research activities relating to all growth and value investment portfolios. In addition, Fay serves as CIO of Global Value Equities, overseeing the portfolio management and research activities related to cross-border and non-US value investment portfolios. From 1999 to 2006, she was CIO of European and UK Value Equities, serving as co-CIO from 2003 to 2006 after being named CIO of Global Value Equities in 2003. From 1997 to 1999, Fay was CIO of Canadian Value Equities. Prior to that, she had been a senior portfolio manager of International Value Equities since 1995. Fay joined the firm in 1990 as a research analyst, subsequently launching Canadian Value, the firm’s first single-market service focused outside the US. She then went on to launch the company’s UK and European Equity services and build Bernstein’s London office, home of its first portfolio management and research team based outside the US. Fay holds a BA from Brown University and an MBA from Harvard Business School. She is a CFA charterholder. Location: New York

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