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Decline - I am not an Institutional Investor

Investors who had already implemented a low volatility strategy as part of their equity allocation fared significantly better. As a proxy, a global minimum volatility index captured only 60% of 2022’s year-to-date decline in global equities (-12.1% vs. -20.3%), outperforming substantially since the beginning of 2021.1 Those enduring the previous period in which defensive stocks lagged the growth-led, cap-weighted indexes during the roaring returns of 2020-2021 were finally compensated with drawdown protection. Those not already committed to low volatility as a diversifier in their equity lineup, however, could be wondering: is it too late?

Two near-term concerns regarding low volatility exposure may be at the forefront of asset allocators’ minds:

  1. Is the drawdown over, i.e., has the opportunity to benefit from their downside protection passed us by?
  2. Are future interest rate increases a serious headwind for the traditionally defensive sectors (e.g., utilities, real estate) that low volatility strategies tend to overweight?

We hope to alleviate both worries via some historical analysis.

Contextualizing 2022's Start

Since bottoming on the reaction to the spread of Covid-19 in March 2020, global equities returned over 80%2, perhaps counterintuitively in the face of the economic consequences of a global pandemic. Financial and monetary stimulus propelled valuations to levels reminiscent of the early 2000s tech bubble. But lingering supply-side constraints drove inflation to the highest year-over-year increase since 1981, and central banks finally signaled their willingness to pull the reins on an overheating economy by raising the federal funds rate higher than we’d seen in a decade in just a matter of months.

If you were keeping abreast of financial news on July 1st, it would’ve been difficult to avoid the ubiquitous headline announcing that the S&P 500 Index had gotten off to the worst six-month start since 1970. The U.S. large cap index saw a nearly 20% decline led by the very same growth stocks that had dominated most of the low interest rate environment of the previous five years (see figure below). Non-U.S. developed and emerging markets fared similarly.

Year to Date Equity Market Returns_Fig_1

As we noted in our introduction, minimum volatility indexes fared much better, capturing less than two-thirds of the decline and outperforming by at least 7% over those six months.

After a drawdown this severe, it may be tempting to hope that the worst is behind us, and the market correction is complete. Historically speaking, however, it often gets much worse. The figure below places the current drawdown (through June 2022) amongst the worst fifteen drawdowns that we’ve seen since 1928. While it ranks 10th in terms of magnitude, at only 118 trading days, it’s far shorter than the average of 268 days. In other words: despite a glimmer of a rebound in July, we may not be done yet.

Largest Historical S&P 500 Drawdowns_Fig_2

The combined hangover from the stimulus and supply chain disruption of the pandemic are uncharted territory for the world’s developed, modern economies. Add in a disruptive conflict between the world’s 2nd largest oil exporter (Russia) and the ‘breadbasket of Europe’ (Ukraine) with no end in sight, as well as rising tensions between the U.S. and China, and it’s easy to see significant potential for the further economic fallout and its potentially volatile, negative effect on stock prices.

Rising Interest Rates and Low Volatility Equity Strategies

Many investors may assume a low volatility equity strategy is going to be significantly overweight traditionally defensive sectors like consumer staples and utilities and “bond proxy” stocks, which typically feature lower standard deviation and beta relative to the broader market. These types of issuers are often more in favor during low-interest-rate environments due to their dividend payments when yield is harder to come by via fixed income securities. Consequently, many investors also assume low volatility strategies are prone to underperformance in extended rising rate environments, as capital shifts from equities with high dividend yields to fixed income securities that naturally rise in yield with the federal funds rate.

As we covered in our paper, Evaluating and Implementing Defensive Equity Strategies, a low volatility equity approach comes in two flavors: heuristic and optimization-based. While the former is primarily relying on a collection of low volatility stocks, the latter utilizes estimates of volatility and correlation to construct a low volatility portfolio. While defensive sectors will still be held at a higher weight than a cap-weighted index, an optimized approach mitigates the necessity of naively crowding into defensive, high-yield names. As the figure below shows, a hypothetical optimized approach may often have a marginal underperformance in reaction to rising interest rates in the short term, but it is also essentially unaffected over three-year periods on a beta-adjusted basis. The takeaway for investors is that introducing a low volatility equity component to their equity allocation is not something they need to shy away from, regardless of their view on whether more near-term interest rate increases are unlikely or a certainty, as long as they adopt an optimization-based approach.

Hypothetical Low Volatility Excess Return vs Interest Rate ChangesFig_3

The Low Vol Value Proposition

We hope we’ve addressed two near-term concerns for low volatility equity investors above, but whether during periods of uncertainty or over a full market cycle, we believe they have a place in any equity allocation for the long haul. Download the full paper to hear our case for long-term low volatility.

Is it Too Late for Low Volatility?  Why Low Volatility Can Still Help Your Portfolio Download Now



1 MSCI World Minimum Volatility vs. the MSCI World Index. Past performance cannot guarantee future results. Returns include the reinvestment of dividends and other earnings.

2 Cumulative return for the MSCI World Index from 4/1/2020-12/31/2022 was 80.26%. Past performance cannot guarantee future results. Returns include the reinvestment of dividends and other earnings.

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Hypothetical performance results presented are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.

Low volatility strategies are likely to underperform the index during periods of strong up markets and may not achieve the desired level of protection in down markets.

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