Strategies to Mitigate Volatility

Volatility Rising

Since the onset of the global pandemic, investors have endured significant periods of elevated market volatility that have not been seen for nearly a decade. Most recently we’ve seen growing fear and uncertainty caused by rising inflation, the scaling back of many central bank stimulus programs and geopolitical concerns around Russia’s invasion of Ukraine. The chart below illustrates how increased volatility, as measured by the CBOE Volatility Index (VIX), tends to coincide with a decline in stock prices. Volatility spiked sharply at the onset of the global pandemic in March 2020 along with a significant decline in equities. As the recovery gained momentum, volatility levels receded as investor confidence and optimism improved. In the first quarter of 2022 investors once again saw volatility return which also corresponded with a drawdown in equities. This has many investors searching for ways to protect the gains they have made and mitigate the impact of potential ongoing volatility.

Rising Fear & Uncertainty

CBOE Volatility Index (VIX) and S&P 500 Index

Source: Federal Reserve Bank of St. Louis for the period March 30, 2012 to March 31, 2022. One cannot invest directly in an index.

The good news is that there are tools and strategies available to help investors ride out these periods of elevated volatility and potentially improve risk-adjusted portfolio returns over the long-term. Building a globally diversified portfolio that includes traditional asset classes and alternatives can help reduce the impact of volatility and offer some protection against market downturns. We can see the importance of reducing the impact of drawdowns and shortening the time required to recover losses in the illustration below. By reducing the magnitude of significant drawdowns, investors can be better positioned to recover losses and potentially achieve a more consistent return profile over time.

Required Returns to Recover Losses

required returns to recover loss

Source: AGF Investments. The example provided is hypothetical and not based on actual performance. For illustrative purposes only.

Alternatives to Mitigate Volatility

Alternative investments can provide investors with additional tools to increase diversification in their portfolios with products that can mitigate risk, especially in a volatile market environment. There are a growing number of products in the marketplace that are now available including both alternative strategies and alternative asset classes. Examples of alternative strategies include market neutral, long-short and global macro while examples of alternative asset classes include private credit, private equity, infrastructure and real estate.

Why Alternatives for Today’s Markets?

With concerns over rising interest rates, inflation and market volatility, alternatives may be especially well positioned to provide investors with several potential benefits. Alternatives tend to behave differently than traditional equity and fixed income investments and adding them to a portfolio may provide investors with several potential benefits including:

  • Diversification through low to non-correlated returns
  • Potential for downside protection and capital preservation
  • Hedging against rising interest rates and inflation
  • Improved risk-adjusted returns
  • Increased yield potential

 

An Alternative Approach for Portfolio Construction

Looking at the illustration below, we can see how the Dow Jones U.S. Thematic Market Neutral Low Beta Index performed relative to traditional stock and bond indexes in the first quarter of 2022. At a time when stocks were in negative territory, we also witnessed bonds losing ground, dragged down by rising interest rates and not offering the same level of protection investors may have come to expect. Over the same period, the market neutral anti-beta index delivered a positive return, demonstrating its value as a potential hedge against equity market volatility.

Total Ret YTD (Daily) Base Currency

Source: Morningstar Direct from January 1 2022 to March 31, 2022 in U.S. Dollars. One cannot invest directly in an index.

Positioning Fixed Income to Mitigate Volatility

Traditional bonds and bond funds have also come under increased pressure owing to growing inflation fears and rising interest rates. Even still, despite expectations for continued rate hikes by many central bankers, bonds continue to play an important role as part of diversified portfolios as a means to offset equity market volatility and generate income.

In an increasingly challenging environment for traditional assets such as government bonds, there are alternative areas within the fixed income universe that can offer the potential for higher yields and increased diversification. Exposure to a broader range of global fixed income securities including high yield bonds, convertible bonds, treasury inflation protected securities (TIPS)* and emerging market bonds can offer a strong complement to traditional bonds. This is due to the structure of the securities, the different drivers of return and lower sensitivity to interest rates relative to traditional bonds. Actively managed, global unconstrained fixed income strategies are one way to obtain this exposure. Another option is “core plus” fixed income strategies that combine a high-quality investment grade portfolio with select exposure to these alternative fixed income securities. We can see below how in the past, different fixed income categories have offered attractive returns relative to traditional bonds.

Look Beyond Traditional Bonds for Diversification & Higher Potential Yields

2021 2020 2019 2018 2017
FR Loans
5.20%
Global Conv. Bonds
34.50%
Global Conv. Bonds
13.66%
CAD Gov't Bonds
1.53%
Global Conv. Bonds
16.06%
Global Conv. Bonds
2.45%
Global Bonds
9.20%
EM Bonds
13.11%
Global DM Bonds
1.12%
Global HY Bonds
10.43%
Global HY Bonds
0.99%
CAD Corp. Bonds
8.74%
Global HY Bonds
12.56%
CAD Corp. Bonds
1.10%
EM Bonds
8.17%
CAD Corp. Bonds
-1.34%
CAD Gov't Bonds
8.69%
U.S. Bonds
8.72%
FR Loans
0.44%
Global Bonds
7.39%
U.S. Bonds
-1.54%
U.S. Bonds
7.51%
FR Loans
8.64%
U.S. Bonds
0.01%
FR Loans
4.12%
EM Bonds
-1.65%
Global HY Bonds
7.03%
CAD Corp. Bonds
8.05%
Global Conv. Bonds
-1.15%
U.S. Bonds
3.54%
Global DM Bonds
-2.41%
EM Bonds
6.52%
Global Bonds
6.84%
Global Bonds
-1.20%
CAD Corp. Bonds
3.38%
CAD Gov't Bonds
-2.97%
Global DM Bonds
4.88%
CAD Gov't Bonds
6.42%
EM Bonds
-2.46%
CAD Gov't Bonds
2.18%
Global Bonds
-4.71%
FR Loans
3.12%
Global DM Bonds
4.75%
Global HY Bonds
-4.06%
Global DM Bonds
1.07%

Source: Morningstar Direct, December 31, 2021. All returns in local currency. One cannot invest directly in an index.

Positioning Equities to Mitigate Volatility

For more than a decade market observers have seen a wide divergence in the performance of growth stocks and value stocks, with growth-oriented equities outperforming value stocks by a wide margin. More recently we’ve seen a change in leadership with the value style climbing ahead of growth stocks. Underlying business operations of many value stocks are tied to the general economy and once investors refocused on the economic re-opening and less so on the ‘work from home stocks’ (which increased in popularity during the pandemic) a reversion to the mean happened. The combination of rising interest rates and increased demand for energy has given a boost to more cyclical value sectors such as energy, materials and financials. At the same time, certain growth-oriented sectors began to struggle including lower-quality (and previously popular) technology names which precipitated the sell-off in growth earlier this year. For growth stocks, rising interest rates tend to exert downward pressure on expensive multiples. The value of each future dollar is eroded as interest rates, which are used to discount future cash flows, rise, pushing down the valuations of these companies. Value stocks, on the other hand, tend to have stronger current cashflows with less emphasis on future growth expectations. These factors have created an environment with opportunities for active managers to seek out the higher-quality companies that have been unduly punished and can be bought at more reasonable valuations. 

Growth and Value Over the Last Decade

Growth and Value Over the Last Decade

Source: Morningstar Direct as of March 31, 2022 in U.S. Dollars. One cannot invest directly in an index.

Today, many investors may be left wondering if the next ten years will look similar to the last decade. We do know that historically growth and value have exchanged leadership positions many times and that over the long-term, markets will go through many different environments. As we navigate today’s volatile markets a combined approach may be worth considering. Over the last year we can see that an equally weighted combination of both value and growth style stocks would have performed favourably compared to a dedicated growth portfolio with considerably less risk.

Combining Growth & Value to Mitigate Volatility

Combining Growth & Value to Mitigate Volatility

Source: Morningstar Direct from April 1, 2021 to March 31, 2022 in U.S. Dollars. One cannot invest directly in an index.

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