Volatility continues to hit record lows despite political upheaval and the start of interest rate normalisation. But, as inflation continues to take root, can active strategies help investors protect their portfolios from downside risk?
Volatility: how low can it go?
Over the last year, volatility has remained stubbornly subdued, hitting new lows on a regular basis. This trend has been seen across many markets and asset classes, including the often unpredictable emerging markets. U.S. equities led the way, shrugging off public policy uncertainty, the Fed’s rate hikes and natural disasters.
How low can it go?
30-week rolling volatility for the MSCI World index
Source: Bloomberg. 1/12/17. 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.
Looking ahead, several key risk factors could come into play. There is considerable uncertainty around key geopolitical relationships and the pace of monetary policy tightening. As global growth takes hold, central banks are beginning to rein in their unprecedented quantitative easing programs. Many countries also have a long way to go in implementing structural reforms. And with bond and equity prices looking increasingly expensive, particularly in developed markets, markets have a lot to navigate in the year ahead.
The question moving into 2018 is: can volatility remain this low indefinitely? Will interest rate normalisation put a spanner in the works? And, if volatility does pick up, how can investors not only manage the associated risks, but also take advantage of the opportunities presented?
“Inflation is beginning to show signs of life from what is a long, slow bottoming process.”
— Western Asset
“Many [risk models] may now be increasingly underestimating the true level of risk in portfolios.”
— Martin Currie
Ready to revert?
Traditionally, volatility has been mean-reverting, returning to average levels over time. Analysis from global equity manager Martin Currie suggests volatility is now at 50+ year lows. Large declines in correlations between stocks, as well as a drop in the individual volatility of stocks themselves, are behind this phenomenon.
However, markets may soon have to react to the potential uncertainty around monetary policy normalisation in the face of global growth, ongoing structural reforms and elevated asset prices. In terms of volatility, EnTrustPermal believes “it is hard to imagine more of the same.”
If tighter labor markets and higher inflation start to emerge due to sustained global growth, it could initially cause higher volatility in fixed income markets, which may then feed into equity markets. Equity volatility tends to lag changes in the yield curve by around 30 months, according to ClearBridge Investments. In their view, while quantitative easing acted as a pacifier of volatility, quantitative tightening may act as an accelerant.
Fixed income as a leading indicator of volatility
Source: Bloomberg, 1/12/17. 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
Sharper spikes to come?
A prolonged period of low volatility can also act to increase the scale of volatility once it returns. Many of the risk models underlying portfolios are built using measures of short-term historical volatility. As a result, many may now be “increasingly underestimating the true level of risk in portfolios”, according to Martin Currie. A pick up in volatility could, therefore, lead to a more rapid market response as risk models adjust from their low base.
Furthermore, investors are expecting markets to continue to perform well as the economic environment remains benign. Hence, the risk of disappointment is skewed to the downside. Moving into 2018, any deviation from expectations could cause an outsized movement in asset prices.
What investors can do
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.
- Buy low-volatility stocks: One approach to the challenge of an uptick in equity volatility is to explicitly seek out stocks with properties that can minimise volatility, both individually and as components of an overall portfolio. A good example is companies with strong dividends that are sustained by the financial and business fundamentals of their underlying businesses. Strong dividends cushion the effect of price volatility in difficult markets. In addition, the overall financial characteristics of strong dividend payers can reduce a stock’s vulnerability to rapid market changes.
- Move fixed income away from benchmarks: A more flexible, unconstrained approach may help manage risk, by allowing greater scope to access the full global bond landscape as well as individual security selection. By dynamically shifting allocations in line with market conditions, unconstrained managers can 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.
- Go active: As volatility feeds into equity markets, active management may also help to manage risk. For example, strategies designed to invest in stocks with a historical tendency to resist periods of volatility can help protect portfolios from the full scale of any downturns. Lower correlations among stocks and a higher dispersion of returns across the market also creates more winners and losers. As Martin Currie notes, “We are conscious of increasing dispersion in returns within the asset class, and the consequent need for investors to be selective. This is best achieved through taking an active, fundamentally driven approach to investment, and a focused, stock-picking strategy is very well placed in this regard.” Such an approach can focus on the 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 (ESG) 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 with an ESG framework can also be an engaged investor, working with companies to create sustainable long-term returns.
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Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
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