By Chris Marx and Kent Hargis
As talk of an early Fed “tapering” triggered a sell-off in bonds, safe-haven equities have also suffered. Can low-volatility strategies survive rising rates and an unraveling of the safety trade, in which investors rushed headlong into safe assets no matter the cost? We say, yes — but you’ll need an active approach to navigate the near-term pitfalls.
Some corners of the low-beta universe have become overcrowded and pricey as ultra-low rates drove an intense hunt for yield. High-dividend-paying and traditionally defensive stocks, for example, are trading at some of the richest valuations of the past 20 years. This leaves them vulnerable to a recovery-induced rise in interest rates, which would favor cheaper, racier cyclical stocks.
But we view the low-volatility opportunity more broadly, and with a stock picker’s eye.
Unlike passive low-volatility index-tracking strategies and ETFs — which are prone to risky concentrations in popular stocks — active strategies can steer clear of these overpriced pockets and lean more heavily on more attractive opportunities elsewhere in the space.
And opportunities are out there. Our research shows that combining low beta with traits of fundamental quality — which we define as high, sustainable profitability, strong return of cash to shareholders and good capital stewardship — is even more powerful than targeting either component on its own. Why? Because low volatility and quality factors tend to work best at different times: when one is facing headwinds, the other provides support.
This complementary tag-teaming has been particularly beneficial in past periods of above-trend rises in 10-year U.S. Treasury yields (Display). The highest quality quintile of stocks strongly outperformed a generally buoyant global market. As would be expected, the lowest-beta quintile trailed, although our research found that this underperformance tended to narrow, the longer rallies ran (a rising tide lifts all boats).
As important, quality hasn’t attracted big crowds like other parts of the low-volatility world. For instance, the stocks of highly cash-generative companies are trading at historically low price/forward earnings multiples and at some of the biggest discounts to the market since 1990 (Display below, top), reflecting worries that this cash will be ill-spent. Companies with aggressive stock buybacks also look reasonably priced versus history (Display below, bottom).
Active strategies can adjust exposures depending on insights into current fundamental attractiveness and risk, even pivoting into sectors not typically associated with low volatility. For instance, we’ve found attractive opportunities in technology services companies with large installed bases and low capital needs, and in nonlife insurers that offer stable industry conditions, good capital discipline and diversification owing to the unique nature of their risks. Within healthcare, a classic low-beta sector, we favor large, diversified pharmaceutical companies, which are still selling at big discounts to the market, and we avoid erratic, event-driven biotech firms.
Turning points in interest-rate cycles are messy, and divergent growth expectations around the world are adding to the uncertainty. With markets likely to remain volatile for some time, we think an equity strategy offering systematic downside defenses should continue to hold broad appeal. Active approaches can add value in a variety of environments and can be used to meet a variety of investor objectives within an overall portfolio. In our view, stability deserves a permanent place in most investors’ portfolios.
Chris Marx and Kent Hargis are the portfolio managers of the Low Volatility Equities services at AllianceBernstein.