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
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