How to Prepare for Market Volatility Before It Strikes Again

Investors who seek defensive equity portfolios might think they need to sacrifice long-term return potential to reduce volatility. However, they may be surprised to discover how a strategy targeting stocks that have historically lost less in a downturn can in fact beat the market over time.

Relative vs. Absolute Risk in a Choppy Market

Too often, investment managers are consumed with relative risk—tracking their performance against a market-cap-weighted benchmark index. This can conflict with what really matters to investors: absolute performance and how well an investment addresses long-term financial goals.

The issue becomes especially thorny during bouts of market volatility, such as the 2022 downturn. Amid stubborn inflation and economic slowing last year, the S&P 500 retreated by 18.1%. While stocks have recovered sharply in 2023, the potential for more volatility is a clear and present danger amid macroeconomic uncertainty and ongoing concern about inflation and high interest rates. When markets are rising, investors don’t always prepare for turbulence. Yet we think the best time to build a defensive plan for an equity allocation is before volatility strikes.

Low-volatility strategies can come in different forms. We believe that an effective defensive strategy should be grounded in company fundamentals and focus on firms that exhibit characteristics of quality (consistent cash flows and measures of profitability like return on invested capital), stability (low volatility of returns relative to the market) and attractive pricing that make them less susceptible to wide market swings. We refer to this as the QSP universe. While companies in traditionally defensive sectors like consumer staples and utilities are good examples, the QSP universe includes firms with standout business models in every sector of the economy, which can be uncovered through fundamental research and thoughtful stock selection.

But here’s the catch: to realize these long-term excess returns, investors would need to accept that a 90%/70% portfolio does not behave in the same way as the broader market.

That’s an easy pill to swallow when the market is whipsawing the way it did last year. After all, in market downturns, this low-volatility strategy would only expose investors to 70% of the market’s downside. The real test comes during rallies, when the 90%/70% would underperform the market. This is the price to be paid for potential market-beating long-term returns. (Display)

Putting Low Volatility to the Test: Recessions

So how would a low-volatility QSP strategy fare in recessions?

Our research suggests that S&P 500 stocks segregated into the highest quintile for QSP characteristics fared relatively well during downturns. For example, the top quintile of the S&P 500 based on quality, stability and price fell by 36.9% during the 1973–1974 recession triggered by the OPEC oil embargo—less than the S&P 500’s 42.6% decline (Display). And during the recession of 1980–1982, QSP stocks actually gained 8.5%, while the market fell by 16.5%.

Redefining Offense and Defense in Equities

At the same time, investors in defensive stocks may be concerned about being left behind in rising markets, such as this year’s technology-driven rally. We believe that technology stocks can play an important role in a low-volatility allocation.

Many of the high-quality, profitable technology companies that operate behind the scenes don’t face the same risks as the consumer-facing giants. These include lower-profile technology enablers and payment-services firms that have sustainable business models and large, recurring revenue streams. While it might sound counterintuitive, we believe that select technology stocks with these attributes exhibit defensive characteristics, while also offering more participation in market upside. In other words, the traditional roles of offense and defense in equity allocations are being redefined, in our view.

Low-Volatility Strategies Can Be Tailored

In any market or macroeconomic environment, a low-volatility strategy can be paired with other active strategies to meet an investor’s individual risk tolerance, time horizon and investment goals. And although it’s not easy to construct a perfect 90%/70% portfolio, the main idea is to reduce exposure to market swings that can erode long-term returns.

Through fundamental research, we believe that it’s possible to construct a portfolio of attractively valued companies with important indicators of quality and stability that can prosper in rallies while withstanding periodic bouts of volatility. In times like these, a smoother ride may be just what investors are looking for.

Investors seeking to position their portfolios to help weather equity market volatility may wish to consider the AB US Low Volatility Equity ETF (Ticker: LOWV). The actively managed fund, which is managed by AllianceBernstein’s Low Volatility Equities Team, is a high-conviction equity portfolio designed to outperform US markets over a full market cycle, while emphasizing downside risk mitigation through tumultuous equity markets.

For more information on the AB Low Volatility ETF, you can CLICK HERE.