After years of chasing safety at all costs, investors are now reaching for opportunities in long-spurned riskier stocks. But they will still want to safeguard their portfolios against painful market swings in the future.
Our research has found that adding a “stability” bucket to an investor’s overall portfolio can provide the downside defenses investors need in the long term, while still capturing equity upside potential in rallies.
Research going back to the 1970s shows that less volatile stocks tend to outperform the market over long periods (Display). Steadier stocks typically compound more of their gains than riskier stocks over full market cycles, in part because they don’t lose as much in selloffs. And preserving capital in downturns can have a big impact on performance in the long run (we think of it as gaining more by losing less).
Reflecting their countercyclical nature, low-volatility stocks have very low correlations with traditional equity strategies (higher-risk, higher-return low-valuation, small-cap and high-price-momentum stocks.) Thus, low-volatility strategies offer strong diversifying benefits.
This is no small point. In recent years, amid widespread macroeconomic fears, correlations reached unusual levels as stock prices moved in the same direction, defeating traditional methods of diversifying equity risk by style and capitalization. This was not true of less volatile stocks. Our analysis found that a hypothetical low-volatility portfolio held up better than value, small-cap and price-momentum portfolios during the global financial crisis. Interestingly, it was the only strategy to rise during the 2010–2011 European debt crisis.
Strategies that explicitly target low volatility and those that target high fundamental quality—such as high return on assets, strong cash generation and disciplined balance-sheet management—are both effective at capturing equity returns with less risk. But our analysis indicated that combining these two strategies generated even stronger risk-adjusted returns than either approach alone, mainly because of their complementary behavior over a full market cycle.
In simulations since 1989, we found that a high-quality portfolio worked best in bull markets, whereas a low-volatility portfolio was much better at tempering losses in market slumps. Over the long run, a portfolio that combined both characteristics maintained the higher return potential of a portfolio of stocks chosen simply for its high quality, and reduced risk more than a portfolio chosen strictly on the basis of a passive low-volatility screen.
We believe that active management is the way to go in low-volatility investing. Unlike approaches that passively invest in less volatile stocks, active low-volatility strategies can adjust exposures based on valuation and other fundamental factors to manage risk and boost return potential.
Many of the winners in the recent risk rally are the economically sensitive or controversial stocks that were most unloved when safety was all that mattered. This reversal is a healthy development, though it proved challenging for low-volatility strategies in the latter half of 2012. Over the long run, however, we believe that an active approach combining quality and low volatility will serve investors well, by enabling them to participate in sustained equity rallies while also protecting against the inevitable rough patches along the way.
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.