Volatility continues to hit record lows despite political crosscurrents and the start of interest rate normalization. But, as inflation continues to take root, can active strategies help investors protect their portfolios from downside risk?
Volatility: defying gravity?
Volatility has remained stubbornly subdued, hitting new lows on a regular basis. This trend has been seen across many markets and asset classes. U.S. equities led the way, shrugging off public policy uncertainty, the Fed’s rate hikes and natural disasters. At the same time, according to Western Asset: “Inflation is beginning to show signs of life from what is a long, slow bottoming process.”
How low can it go?
30-week rolling volatility for the MSCI World index
Source: Bloomberg, December 1, 2017. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
However, markets soon may have to react to the potential uncertainty around monetary policy normalization in the face of global growth, ongoing structural reforms and elevated asset prices. In 2018, as central banks continue to rein in their unprecedented quantitative easing programs, as ClearBridge Investments notes, this could “initially cause higher volatility in fixed income markets, and eventually cause volatility to rise among equities.”
“While quantitative easing acted as a pacifier of volatility, we view quantitative tightening as an accelerant.”
— ClearBridge Investments
The implications of higher volatility for portfolios are not always negative, but investors may feel the need to consider their investment approach in the light of its potential resurgence.
- Low-volatility stocks: One approach to the challenge of an uptick in equity volatility is to explicitly seek out stocks with properties that can minimize volatility, both individually and as components of an overall portfolio. One such characteristic: a strong dividend that is sustained by the financial and business fundamentals of its underlying company, which may cushion the effect of price volatility in difficult markets. In addition, the overall financial characteristics of consistent dividend payers can help limit a stock’s vulnerability to rapid market changes.
- Unconstrained fixed income: A more flexible, unconstrained approach may help manage risk. An active manager with greater discretion and scope to explore the global bond landscape could make selective decisions that seek to avoid excessive risk and address concerns around valuations. They could also dynamically shift allocations in line with market conditions. This allows managers to identify the most compelling, potentially undervalued bond markets and currencies — as well as regions, countries or sectors that offer a better yield or where duration risk should be rewarded — while avoiding or even shorting areas of concern.
- Active strategies in general: As volatility feeds into equity markets, active management may also help to manage risk. Strategies designed to invest in stocks with a historical tendency to resist periods of volatility, for example, can help protect portfolios from the full scale of any downturns. And as Clearbridge argues: “A normalizing of volatility levels can also create conditions that favor active management.” Lower correlations among stocks and a higher dispersion of returns across the market create more winners and losers. A high-conviction, selective stock-picking approach can focus on fundamentals for each individual security to help identify which will win and which will lose. It can delve deeper into those companies, gaining a better understanding of their future prospects. This additional information, particularly around environmental, social and governance issues, can increase a manager’s conviction in the sustainability of a company’s returns, even during periods of market volatility. An active manager also can be an engaged investor, working with companies to create sustainable returns.
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