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

Five reasons to hold your investment nerve

VIX, XIV and all that jazz

Howard Marks on risk and how To handle It today

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

AFIC on its record discount, passive investing and pricey stocks

A triple headwind has seen Australia's biggest LIC swing to a 10% discount and scuppered its relative performance. Management was bullish in an interview with Firstlinks, but is the discount ever likely to close?

Latest Updates

Investment strategies

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

Investment strategies

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Shares

Australian shares struggle as 2020s reach halfway point

It’s halfway through the 2020s decade and time to get a scorecheck on the Australian stock market. The picture isn't pretty as Aussie shares are having a below-average decade so far, though history shows that all is not lost.

Shares

Is FOMO overruling investment basics?

Four years ago, we introduced our 'bubbles' chart to show how the market had become concentrated in one type of stock and one view of the future. This looks at what, if anything, has changed, and what it means for investors.

Shares

Is Medibank Private a bargain?

Regulatory tensions have weighed on Medibank's share price though it's unlikely that the government will step in and prop up private hospitals. This creates an opportunity to invest in Australia’s largest health insurer.

Shares

Negative correlations, positive allocations

A nascent theme today is that the inverse correlation between bonds and stocks has returned as inflation and economic growth moderate. This broadens the potential for risk-adjusted returns in multi-asset portfolios.

Retirement

The secret to a good retirement

An Australian anthropologist studying Japanese seniors has come to a counter-intuitive conclusion to what makes for a great retirement: she suggests the seeds may be found in how we approach our working years.

Sponsors

Alliances

© 2024 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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.