For decades, U.S. and European institutional investors have been de-risking their portfolios by shifting from equities into fixed income or alternatives. Fixed income can always reduce risk, but the relative cost of doing so varies with interest rates and equity valuations. Hedge funds offer the promise of equity-like returns without the equity risk, and private equity offers much higher return potential, but with significant liquidity constraints. Low-volatility equities are a third option for investors to consider because they offer a means to reduce risk without sacrificing equity allocations or holding illiquid assets.
Views vary, of course, but most CIOs are focused to some degree on de-risking. According to the CIO of a U.S. state retirement fund, his team tries to “estimate fair value of all assets on an ongoing basis, and observe whether prices at any moment are below or ahead of that value. Right now, we feel the equity markets are about 25% overvalued, and that’s just enough perceived overvaluation to trip our thresholds for us to go to our minimum risk exposure, and we are making progress toward that.”
Traditionally, the easy way to de-risk is to move from higher risk asset classes to lower risk asset classes. In 2009, about 35% of institutional investors’ portfolios consisted of public equities, a percentage that has dropped to around 20% today, according to Greenwich Associates’ study “Asset Allocation Trends in Institutional Asset Management, 2018 U.S. Institutional Investors Research.”
Clearly, de-risking in and of itself is not the challenge – the main hurdle is how do investors de-risk without sacrificing returns in an iffy return environment. According to one recent survey of U.S. state and local pension funds, the average rate of return assumptions across 129 plans is 7.3%. However, a review of Northern Trust Asset Management’s Capital Market Assumptions asset class return forecasts shows that no single asset class, with the exception of private equity, has an expected return above 6.5%, and a vanilla 60/40 portfolio only expects to produce around 4.7%, leaving a 2-3% shortfall for the return assumptions among that cohort of pension plans.
Quick Q&A with Michael Hunstad, Ph.D., Head of Quantitative Strategies at Northern Trust Asset Management
II: Can investors determine if they’re prepared for risk going forward?
Investors became somewhat ambivalent about risk during the long period of low risk, low volatility, and high returns – it almost didn’t matter how much risk you were taking. Going forward, that is all changing. So, the first step to determining if you’re ready for what’s coming is to determine the source of risk in your portfolio. Is it asset allocation, or within the asset class itself? The most important consideration today is the risk within the asset class. If you are dominantly exposed to risk you aren’t compensated to take, you aren’t really prepared for what’s ahead.
II: Are we at a market inflection point?
From the real side of the economy, no. Our view is that over the next five years we will not be entering a recession. But, keep in mind that even if the real side remains relatively stable, the volatility of the markets doesn’t necessarily behave the same way. Are we at a volatility inflection point? Absolutely. We’ve already passed that inflection point. The future will be very different from the past, so that inflection point is critical in thinking about how you’ll prepare portfolios for solid but muted growth going forward, accompanied by a lot more volatility.
II: How is the future going to look different from the past?
We’ve seen a rise in realized volatility and more dispersion in sectors and country returns, for example. There are a lot more elements of risk operating under the hood. This creates issues, especially for actively managed strategies within the fixed income or equity space. For example, so far in 2019, the markets have had a little higher volatility, but there has been tremendous sector rotation. January and February were completely risk on, and we saw the cyclical sectors outperform the defensive sectors by as much as 900 basis points. In March, that all shifted around – it was a mirror image, with the defensives outperforming the cyclicals by about the same amount. All of this, while on the surface the markets seemed relatively calm. In a similar scenario going forward, if you aren’t cognizant of that sector rotation, you could be whipsawed.
Learn how to "Strengthen Your Portfolio Core."
For investors who find themselves facing increased volatility and a need to address potential downside risk in an equities market that drives a large part of their portfolio performance, there is some good news.
“Volatility in and of itself impacts the portfolio, but in general, it’s also good for factor performance,” says Michael Hunstad. “Most factors1 do quite well in an above median VIX-environment, when volatility levels are relatively high. Low volatility is very asymmetric in that regard. Growth and momentum factors have done well over the last 10 years being largely below median in terms of volatility. In a higher risk environment – in other words, in the anticipated higher volatility world – quality factors do well, as you might expect, but don’t count out value, size, and dividend yield.”
That insight is part of why there is, in fact, another way for investors to lower volatility and continue to grow their assets, without the potential downside of lowering portfolio return expectations, without the higher fees of alternatives strategies, and without lowering liquidity.
Recognizing the imperative to effectively address investors’ de-risking needs, Northern Trust Asset Management developed its Quality Low-Volatility (QLV) strategy, which is designed to reduce absolute volatility and outperform relative to the market capitalization-weighted benchmark. QLV can be considered as a core equity allocation which seeks to deliver strong market upside potential while reducing downside risk. QLV also uses the quality factor to further reduce volatility and potentially add incremental returns.
1 Factors Defined Quality: The Quality factor targets companies with efficient management, profitability, and strong cash flows. Value: The Value factor targets companies that trade at low current valuations. Low Volatility: The Low-Volatility factor targets companies with less volatile cash flows. Dividend Yield: The Dividend Yield factor targets companies that pay large dividends. Momentum: The Momentum factor targets companies that have strong market sentiment and analyst sentiment. Size: The Size factor targets companies of smaller market capitalization.
