Heightened market volatility episodes have become more frequent in recent years, with several fast and deep corrections.
Ben Dunn, Head of Quantitative Strategies, Eastspring Investments, explores how investors can stay invested while minimising the volatility in their portfolios with a low volatility strategy, thereby reducing the risk of exiting the market at the worst time and missing the market’s best days which can significantly lower their overall returns.
Key takeaways include:
- Market expectations of volatility spiked in March 2020, and have remained at levels higher than we have seen for most of the last decade, initiated by uncertainty over COVID recovery. Other factors that have caused recent market swings include market supply disruptions, China’s property market woes, food and energy prices, and the Russia-Ukraine crisis.
- Investors who are unable to endure the pain of market corrections may decide to exit the market at the worst time, potentially losing out on any sharp market reversal. Low volatility strategies help to minimise losses by falling less during turbulent times, and only need to rise a smaller magnitude to return to the same level – an effect that compounds over time.
- Emerging and Asian markets are typically more volatile than developed markets, having experienced higher drawdowns than the US and Europe during periods of heightened volatility, and taking a long time to recover from these drawdowns. Low volatility strategies in Asia would help investors better navigate market gyrations, and stay invested over the long term.
- Low volatility stocks are usually found in defensive sectors and are typically mature companies with stable earnings, predictable cash flows, and high dividends. Dividend-paying companies are a buffer in an inflationary environment, and a careful selection of good quality, dividend-paying low volatility stocks can cushion against rising inflation.
- While the benefits of low volatility strategies are evident, a key drawback cited is that they tend to lag when the market rallies quickly. COVID, too, highlighted that relying on a single factor approach i.e., low volatility, may not always be effective in achieving the lower drawdowns yet broader market participation that many investors desire. This is why an approach that considers a large universe of stocks rather than only focusing on stocks with low volatility characteristics is preferable. Thus, the resulting portfolio benefits from greater opportunities to add alpha through stocks with attractive fundamental characteristics and then leverages an advanced portfolio construction approach to arrive at a low volatility portfolio.
- This process ultimately yields well-diversified exposure across sectors, countries, industries, and stocks and culminates in a low vol portfolio, not a portfolio of low vol stocks. Long-term investors who wish to remain fully invested in Asia even during periods of elevated volatility can consider complementing their asset allocation with low volatility strategies to help manage risks.
