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Investment Strategy Commentary

Volatility Happens

This year investors received their first reminder in quite a while that market corrections are a regular part of the investing landscape. Since 1928, the market has been in a bull market roughly 75% of the time. But the corrections/bear markets that occur along the way raise recurring questions about portfolio construction and what should be done to “protect” against market sell-offs. We encourage investors to shift their thinking from “protecting your portfolio against volatility” to “reducing your sensitivity to volatility.” Through proper allocation between risk control assets (investment-grade fixed income) and risk assets (everything else), investors can position themselves to ride out the volatility that is inherent in risk assets. We examine in this article two approaches to reducing volatility in portfolios — shifting to lower volatility assets within the risk asset category and executing lower volatility strategies within the equity asset class. We think these asset allocation and implementation strategies will become increasingly important in coming years, as the low volatility markets of the last several years return to more normal conditions.

Long time coming
Exhibit 1 depicts the length of time the S&P 500 has gone without a correction of 5%, 10% or 20% — the higher the triangle, the longer the market has gone without the related decline. The 5% market correction realized in early February 2014 offset an overextended period of calm where the market had gone 150 days without a 5% pull-back (as opposed to the average 50-day duration). We are still extended with respect to larger corrections, having gone more than 600 days without a 10% decline. This is roughly double the average duration during bull markets, but nearly four times the average duration of all market cycles. The perception of an over-extended market — combined with concerns about the impact higher interest rates would have on fixed income investments — has some investors wondering how they can protect their portfolio.

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Bonds have helped in falling, and rising, rate environments
Despite all the worries about portfolio protection from fixed income in a rising interest rate environment, it is worth noting: during the last bond bear market (1963–1981), rates climbed from 4% to 14% and a diversified portfolio assisted in downside protection on seven occasions. In contrast, during the bond bull market of 1994–2012, where rates went from 8% to 2%, bonds only assisted in downside protection on four occasions. The examples shown in Exhibit 2 demonstrate one of our key portfolio construction tenets: during periods of market stress, the best diversifiers are risk-control assets (investment-grade bonds) due to their low- to negative-correlation to equities. In contrast, the various assets within the risk asset category all share sensitivity to global equity prices, including a correlation of 0.56 for Barclays U.S. Corporate High Yield 2% Issuer Capped Index and 0.95 for the MSCI World ex-U.S. Index.

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Can we shuffle our risk assets?
We define risk assets as those asset classes that have notable exposure to changes in stock prices (the equity risk factor) — an exposure that typically becomes acute during periods of stress in the financial markets. As such, we do not rely on these asset classes for robust diversification through all economic cycles. However, some risk asset classes can be used to protect on the downside (while still providing upside participation) in times when heightened volatility is expected. Exhibit 3 provides the full slate of risk asset options alongside two key volatility measures for each. The first risk measure — and the most common one — is standard deviation, which is a measure of how much a particular asset class’s returns can deviate from its average return. Looking at emerging market equities, it would not be surprising to see returns fall within a band of plus or minus 24% — a good deal of risk, and the riskiest asset class we would consider in an allocation.

Another measure we look at is downside risk, which measures reasonable expectations around the potential for negative returns. For instance, using the historical record of emerging market equities, a 16% decrease in any given year should not be considered uncommon. The return potential for emerging market equities is such that we think it is worth considering within an asset allocation, but with that allocation the portfolio is subjected to notable downside risk.

Hedge funds offer a great deal of risk mitigation, but simple risk mitigation is not how a hedge fund manager should be evaluated (as a 60/40 portfolio can provide substantial risk mitigation itself). Rather, hedge fund managers seek to show evidence of true alpha generation to support their higher investment thesis. Other risk assets designed to provide better downside protection than global equities include high yielding fixed income (both corporate high yield and emerging market debt), global listed infrastructure, and commodities. Of course, the return outlook for any of these options is critical — we don’t think an asset class with low volatility but a weak return outlook should earn much allocation in a risk asset portfolio.

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Can we shuffle our equity approach?
Another approach to reducing volatility is to construct an equity portfolio specifically designed for that purpose. In Exhibit 4, we show the risk and return of various equity factors for the period of 1997 through early 2014, and compare them to a global portfolio (MSCI World Index). As can be seen from this data, three factor approaches to equities had lower historical volatility than global equities and also generated better returns. Interestingly, low beta stocks (those stocks less likely to move in the same direction, or at the same magnitude, as the broader markets) outperformed the market at much lower volatility. Although this directly contradicts academic gospel (the efficient market hypothesis and models based on its tenets — such as the Capital Asset Pricing Model or Arbitrage Pricing Theory — say that stock returns are based on exposure to risk factors), this anomaly has been gaining traction in the investment community in recent years. We also believe that higher quality companies (as measured by factors such as profitability, balance sheet productivity, and management decision making) can outperform the general market with lower volatility.

That is not to say the traditional risk factors of size (small cap stocks) and value (cheap stocks on the basis of their book-to-price valuations) have not also provided excess returns. As seen in Exhibit 4, our data shows these risk factors have provided superior returns over time (and, in fact, better than the lower volatility strategies) — but come with additional risk. So although these stocks don’t help reduce the overall volatility within the equity portfolio, they can help serve the purpose of long-term capital appreciation for those portfolios less concerned about volatility. Importantly, both small cap stocks and value stocks have proven their ability in the past to appropriately compensate investors for the increased risk they are assuming. Conversely, our study shows that growth has all the extra risk of value but has not provided the same return premium over longer-term time frames (such as the 17-year period shown in Exhibit 4); while large cap stocks sit fairly close to the overall market profile (not a surprise, given the market is cap-weighted). All risk factors have the ability to outperform for extended periods of time. Therefore, including growth and large cap stocks in an overall portfolio may make sense in an effort to capture these “runs” and attempt to provide stability to the portfolio. However, for the investor with a long-term horizon merely looking to invest in risk factors with the best long-term return potential, size and value may stack up well in that regard.

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Different points within a market cycle bring out different investor issues, and concerns, that need to be researched and addressed. With market volatility being suppressed in recent years (significantly due to active market support from global central banks), it only seems likely to increase over the next year or two. We think investors are best served by reducing their sensitivity to the volatility through proper strategic asset allocation, not by chasing the newest volatility reduction tool. We think there are opportunities to reduce volatility within the risk asset classes, by reallocating to lower risk assets that have attractive outlooks. We also think that investors should be intentional about their approach to equities and select the approach that will best help them reach their objective — be it lower volatility or higher long-term returns.

Past performance is no guarantee of future results.

There is no guarantee that an investment strategy will be successful.

Investing involves risk, including the potential loss of principal.

Alpha measures a fund’s risk-adjusted performance and represents the difference between a fund’s actual performance and its expected performance, given its level of risk.

Barclays U.S. Aggregate Bond Index is an unmanaged index of prices of U.S. dollar-denominated, fixed-rate, taxable, investment-grade fixed income securities with remaining maturities of one year and longer.

Barclays U.S. Corporate High Yield 2% Issuer Capped Index is an unmanaged index that measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds. It is a version of the Barclays High Yield Corporate Bond Index except it limits its exposure of each issuer to 2% of the total market value and redistributes any excess market value index-wide on a pro-rata basis.

Ibbotson U.S. Intermediate-Term Government Bond Index is an unweighted index constructed from monthly returns of non-callable bonds with maturities of not less than five years, held for the calendar year.

MSCI All Country World Index (ACWI) is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices.

MSCI World ex USA Index captures large and mid cap representation across 23 of 24 Developed Markets DM countries—excluding the United States. With 1,006 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

S&P 500® Index is an unmanaged index consisting of 500 stocks and is a widely recognized common measure of the performance of the overall U.S. stock market.

It is not possible to invest directly in an index.

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