Equity strategies to consider to help weather volatility

Volatility reappeared in the U.S. equity markets in the third quarter. The VIX,1 a common measure of market volatility, jumped from July’s low teens to over 40 in August, before settling in the low- to mid-twenties by quarter end. The higher volatility was also accompanied by negative returns. Now, some investors are viewing this as an inflection point for U.S. equities and are gearing up for a lower return, higher volatility market going forward. One way to help portfolios weather this sort of environment may be to incorporate market exposures and/or investment strategies that are positioned to perform under such conditions. For example: high quality stock portfolios and volatility managed strategies. (Note, for the remainder of this blog post, the Russell 1000® Defensive Index (R1D) and the CBOE S&P 500 BuyWrite Index (BXM) will be used as proxies for high quality and volatility managed approaches to demonstrate the merit of such strategies).

A short walk down memory lane

Some investors may recall that high quality and volatility managed strategies were praised in the aftermath of the 2008-2009 market correction because they had held up relatively well during that turbulent time. However, enthusiasm has since waned because neither high quality nor volatility managed strategies have posted exceptionally strong performance since that period. It’s true: since the market bottom in 2009, both strategies have lagged the broader U.S. stock market (represented by the Russell 1000® Index). U.S. Equity / Benchmark annualized returns Sources: U.S. Equity: Russell 1000 Indexes. BXM: CBOE S&P 500 BuyWrite Index The reality is that high quality and volatility managed strategies generally tend to lag during periods of lower market volatility. And that’s exactly the type of market environment investors have enjoyed since 2009. But if that is changing now – if markets are returning to a higher volatility and/or lower return environment – investors may want to reconsider their position on high quality and volatility managed investment strategies.

Historically shining in periods of low market returns

During periods of lower returns (defined as three-year periods when the Russell 1000® Index averages less than 5%), the Russell Defensive Index and the BXM have both posted better average returns than the broad market. Since July of 1986 (inception date of the BXM), the Russell 1000® Index has produced “low” three year returns 28% of the time. During those periods, defensive and low volatility strategies have outperformed the broad market by approximately 2% per year on average. Average annualized returns (%) during "low return" market environments (July 1986 - Sept 2015)

Historically winning in periods of higher market volatility

To evaluate how these strategies have historically held up during periods marked by higher market volatility, we divided the market history into thirds based on the level of volatility over three-year time frames. During the periods with the “lowest” volatility, the broad market generally outpaced defensive and low volatility strategies. However, during periods with “medium” and “high” amounts of volatility, the story shifts. Defensive strategies beat the broad market in both scenarios, and low volatility strategies top both in higher volatility markets. Average Annualized 3-Year Returns During Volatility Regimes (1986 - Sept 2015)

Historically outpacing during periods of low returns and high volatility

Based on the results high quality and low volatility strategies posted during periods of either low returns or high volatility, it should come as no surprise that these strategies have also fared better than the broad market when markets are marked by both volatility and low returns. 3-year average annualized Returns during low return-high volatility periods

The bottom line

It’s difficult to project where the market will go next. There are indications that volatility may be picking up again and many market observers are projecting a lower return environment going forward. Of course, just because high quality and volatility managed strategies have helped portfolios weather high volatility and low return environments in the past, doesn’t mean they will be able to reproduce similar results in the future. However, it may be worth considering them for the U.S. equity part of client portfolios.

1 The VIX index is the commonly used name for the CBOE Volatility Index.