Investors can potentially protect against chaotic markets with quality, low-volatility exchange traded fund strategies to better diversify their core allocations.
In the recent webcast, When Rates Rise, it’s Time to Combine Low Volatility & Quality, Jordan Dekhayser, head of the Quantitative Strategist Team at Northern Trust Asset Management, warned investors that we are in a new age of volatility, with more frequent spikes in volatility. Specifically, he pointed out that there were only five volatility shocks, or any increase in the CBOE Volatility Index or so-called VIX daily greater than five points, throughout 2000 through 2008. In comparison, we experienced 65 volatility shocks from 2008 through 2022.
In this type of era of more frequent market oscillations, investors can turn to style factors to potentially provide excess returns over the broader equity markets over various business cycles. Specifically, the low-volatility and quality factors have traditionally been the best performing market factors during the contraction phase of a normal business cycle, generating an average of 9.4% and 6.4% return, respectively.
The low-volatility factor is becoming more important as we witnessed a widening volatility gap in down and up markets. The low-vol factor has even seen improved upside-to-downside capture ratios in equities over the years.
Dekhayser also advised investors to diversify with improved risk-adjusted returns as more investors are forced to increase risk exposure to squeeze out returns. Specifically, investors could have just gone 100% into the Bloomberg Aggregate Bond Index to generate a desired 5.6% return with a standard deviation of 3.8%. In comparison, a portfolio of private equity, hedge funds, real assets, emerging market equities, international equities, U.S. equities, high yield bonds, and investment-grade bonds would be needed to generate a diversified desired return of 5.6% with a standard deviation of 11.4%.
As a way to improve risk-adjusted returns in this more challenging market environment, Dekhayser highlighted the Northern Trust Quality Low Volatility Total Return Index. Investors who allocate to something like a quality, low-volatility strategy could help diversify a traditional 60/40 stock/bond portfolio while also diminishing the overall portfolio risk exposure or standard deviation. Furthermore, the lowered risk does not mean investors will have to give up returns to do so.
“The Northern Trust Quality Low Volatility Total Return Index historically offers downside mitigation and upside participation with favorable risk-adjusted performance,” Dekhayser said.
As we face increased unknowns and a potentially volatile market response, investors may turn to quality and low-volatility ETF strategies to hedge risks and still maintain upside potential, such as the FlexShares US Quality Low Volatility Index Fund (QLV), the FlexShares Developed Markets ex-US Quality Low Volatility Index Fund (QLVD), and the FlexShares Emerging Markets Quality Low Volatility Index Fund (QLVE).
The three ETFs utilize a quality screen to provide exposure to high-quality companies with lower absolute risk, thereby limiting potential future volatility. The quality screen analyzes a broad universe of equities based on key indicators such as profitability, management efficiency, and cash flow, and then excludes the bottom 20% of stocks with the lowest quality score. The index is then subject to regional, sector, and risk-factor constraints, to manage unintended style factor exposures, significant sector concentration, and high turnover.
Financial advisors who are interested in learning more about the the low-volatility and quality strategy can watch the webcast here on demand