Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 238

Managing the threat of rising volatility risk

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. US equities led the way, shrugging off public policy uncertainty, the Fed’s rate hikes, and natural disasters.

How low can it go?

Source: Bloomberg. 1/12/17.

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 bond and equity prices looking increasingly expensive, particularly in developed markets.

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?

Ready to revert?

Traditionally, volatility has been mean-reverting, returning to average levels over time. Analysis from Legg Mason’s global equity affiliate, 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.

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 Legg Mason global equity affiliate 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. 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.

A prolonged period of low volatility can also act to increase the scale of volatility once it returns. Many risk models are built using measures of short-term historical volatility and 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. A 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. What can investors do?

  • 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. 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 to fixed income 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.

  • Consider active management: 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.”

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.

 

Andy Sowerby is Managing Director at Legg Mason Australia, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor. The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.

 

RELATED ARTICLES

VIX, XIV and all that jazz

Howard Marks on Risk and How To Handle It Today

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.