In 2018, volatility jumped, interest rates rose and a flurry of negative geopolitical and economic news resulted in fragile markets, eventually producing the worst December for U.S. stocks since 1931.
What strategies should investors consider this year?
As a professor and practitioner of finance, I am fascinated by academic research that makes a substantive difference in portfolio outcomes, especially for times when defense is warranted.
In 2006, I teamed with professors Robert Hodrick, Yuhang Xing and Xioayan Zhang to uncover counter-intuitive evidence that more volatile stocks tend to have lower returns than more stable stocks. In fact, our results showed you could create a portfolio that seeks market-like returns with potentially less risk. That paper helped create what we refer to today as minimum-volatility strategies. Minimum volatility is one of several factor strategies supported by decades of academic research that have driven returns over long periods.
Many investors have overlooked the benefits of these defensive factors, choosing instead to sell equities and sit on the sidelines as volatility spikes. But attempting to time exits and entries into markets is difficult, and missing the market’s best days can result in falling short of your long-term objectives. Defensive factor strategies can provide investors an alternative to sitting on the sidelines by constructing portfolios that may be more resilient to market swings.
What factors can do for you
Take a look at a commonly recognized factor —value VLUE, +0.34% — as an example of how factors can potentially help investors. Value favors stocks that are underpriced relative to their fundamentals. Think of it as a discounted item in the grocery aisle that intrinsically may be worth more than its sticker price. Value represents the opportunity to buy on sale. We all love a sale.
That’s the simple, straightforward way to internalize why investing through a factor lens may be beneficial. Factors distill ideas we’re familiar with in other areas of our lives and help us access those characteristics across asset classes.
Quality, as another factor example, focuses on companies with strong balance sheets and stable cash flows. Momentum MTUM, +0.19% tries to take advantage of trending stocks, and small size ISZE, -0.16% tilts toward smaller, more nimble companies. And, of course, the minimum volatility factor helps investors potentially reduce overall portfolio risk.
But just like the broader market, factors don’t outperform all the time. The cyclicality of factor performance tends to coincide with the peaks and troughs of economic cycles. It’s important that investors stay informed of what is happening in the economy and, in turn, what risks may exist for any factor-based strategy they want to use in a portfolio.
Let’s take a closer look at the economic-cycle chart below to see what factors may be particularly helpful for investors today as we enter into a slower-growth environment.
Factors in different economic cycles
Minimum volatility and quality are two factor-based approaches that may perform best during slowdown-and-contraction phases, when growth is decelerating. We covered minimum volatility earlier, but there are hundreds of papers discussing the quality factor as well.
Here’s a closer look at both.
Minimum volatility — remain stable in turbulent markets
During 2018, while the market-cap weighted S&P 500 Index lost 4.4%, a basket of under-appreciated lower-volatility stocks (as measured by the MSCI USA Minimum Volatility Index) was up 1.4%. Minimum volatility’s resilience was readily apparent in the fourth quarter of 2018, as the S&P 500 Index shed 9%, while the MSCI USA Minimum Volatility Index fell 7.1%. In fact, over the past five years, MSCI USA Minimum Volatility Index has delivered a return that is 1.8% higher than the S&P 500 Index, with a reduction of risk (measured as annualized standard deviation) of 18%.
Below, I’ve captured the MSCI USA Minimum Volatility Index’s monthly excess returns over the S&P 500 Index to show the factors’ upside and downside capture. To put the minimum volatility factor to work in your portfolio, consider iShares Edge MSCI Min Vol USA ETF USMV, +0.23%
Quality — seeking shelter from the storm
The quality factor is also defensive in nature, focusing on companies with more stable earnings and clean balance sheets, which are often overlooked. Quality may perform best during an environment of slowing economic growth.
Put simply, the quality factor may shine brightest when it’s raining. If market returns are low or negative, quality may help you offset sharp corrections, as illustrated in the chart below. The ability for quality to shelter investors is shown well in the China market crash (2015) and volatility spike (2018) below.
Consider iShares Edge MSCI USA Quality Factor ETF QUAL, +0.45% for single-factor exposure to large- and mid-cap U.S. stocks exhibiting positive fundamentals.
| MSCI USA Sector Neutral Quality Index Excess Performance vs. S&P 500 Index | |||
| Quality | S&P 500 | Difference | |
| China market crash (June 2015 - Aug. 2015) | -5.46% | -5.92% | 0.46% |
| Volatility spike (Feb. 2018 - March 2018) | -4.08% | -6.13% | 2.05% |
| Source: FactSet | |||
What you could do now
If you’re cautious about a slowing economy, you may want to seek reduced risk in your portfolio. But panicking and selling equities when turbulence hits could cause you to miss out on some long-term returns.
Minimum volatility and quality factors can help give investors the confidence to stay invested.
Remember, when bad weather rolls in, it’s a good idea to seek shelter from the storm and invest in strategies that may help you rest through turbulent markets. Stay focused on your long-term objectives and let factors help do the work for you.
Andrew Ang leads BlackRock’s Factor-Based Strategies Group.