With the potential to deliver equity-like returns with lower expected volatility over the long run, we believe the appeal of managed-volatility exposure within a broader portfolio is apparent. Depending on how the allocation is funded (meaning which combination of traditional stocks and bonds are sold to purchase low-volatility equity), it can allow for potentially higher expected returns, lower expected volatility, or both.

In the two part Making the Case for Managed Volatility series, we will highlight how current valuations support the current case for managed-volatility strategies and how changing inflation expectations should support relative returns going forward.

Greed over fear for the past year

Investor optimism gyrated between growth and value stocks over the last 12 months, although it was almost exclusively between “risky” growth and “risky” value stocks that exhibited higher volatility than the market. This preference to pay for “lottery-like” returns bid up the prices of riskier stocks, while stocks that exhibited more stable characteristics lagged. As enthusiasm waned for mega-cap technology growth stocks at the end of 2020, investors looked to companies that stood to benefit from pent-up consumer demand. Vaccine announcements in the fourth quarter of 2020 triggered a rotation away from “stay at home” stocks into beaten-down “reopening” plays. Exhibit 1 shows that the dynamic was common in all corners of the world as the low-volatility factor lagged globally.

Exhibit 2 shows that pro-cyclical sectors within the U.S.—such as financials, consumer discretionary and industrials—benefited from the recovery environment, and that defensive utilities, consumers staples and health care underperformed. Within riskier names, “cheap” stocks rebounded most significantly, while more expensive names outperformed among defensive, low-volatility stocks.

Where do we go from here?

We believe that strategically, managed-volatility strategies are likely to retain their long-term properties of market-like returns with lower risk. In the long-run, an investor who stays away from “popular” and riskier areas of the market should be able to compound and receive market-like returns with significantly lower risk.
The pandemic-related selloff was an exception because it was not economically driven. It was an exogenous, healthcare-driven event. As much as that exception disappointed managed-volatility investors, we do not believe that it should be over extrapolated. Most shocks are market driven, and we should expect managed volatility to deliver on its long-term properties over full market cycles.

Valuation matters

It should be common sense that buying something cheap is better than buying it at a higher price. Accordingly, one would expect better returns from low-volatility when it is cheap. Exhibit 3, which looks at the performance of low-volatility equities over three years based on their starting valuation, supports this premise.

As Exhibit 4 shows, current valuations are likely to provide a cushion for managed-volatility strategies in a broad market correction as low-volatility equities are now cheaper than at any point over the last two decades.

SEI’s view

Naturally, higher risk-adjusted returns afford investors greater confidence in their ability to achieve their financial goals. Particularly at the lower-risk end of the spectrum, where many investors are concerned primarily with the risk of absolute loss, managed volatility can allow for the possibility of significant long-term growth with potentially smaller expected drawdowns.

In Making the Case for Managed Volatility Part 2: What Matters? we will examine the impact of inflationary expectations on managed-volatility strategies and how higher inflation by itself does not necessarily signify a negative environment.

Glossary

Bear market refers to a period of steadily decreasing stock prices, typically marked by a 20% drop from recent highs.

Bull market refers to a period of steadily increasing stock prices.

Composite refers to a combination of several measurements or data types.

Full market cycle refers to a period of time containing a wide variety of economic trends and market environments, generally including a bull market through a bear market and back again to the start of a new bull market.

Growth stocks exhibit steady price or earnings growth above that of the broader market.

Mega-cap stocks are companies with market capitalizations over $200 billion.

Pro-cyclical stocks tend to be correlated with the overall economy and typically increase when the economy is growing quickly.

SEI Low Volatility Factor Composite is a composite index of underlying ratios that SEI has determined to be appropriate measures of the low-volatility factor.

SEI Value Factor Family is a composite index of underlying ratios that SEI has determined to be appropriate measures of the value factor.

Spread refers to the difference between two values.

Tercile is a number that divides an ordered set of data into three parts, each containing a third of the values.

Value stocks are those that are considered to be cheap and are trading for less than they are worth.

Z-score describes a value’s relationship to the average of a larger set of data.

Index Definitions

MSCI ACWI Index measures the activity of large- and mid-cap stocks in developed- and emerging-market countries.

MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities.

MSCI Europe ex UK Index is designed to measure the performance of large- and mid-cap stocks in developed-market countries (excluding the U.K.) in Europe.

MSCI Japan Index is designed to measure the performance of large- and mid-cap stocks in Japan.

MSCI United Kingdom Index is designed to measure the performance of large- and mid-cap stocks in the U.K.

MSCI World Index measures the activity of large- and mid-cap stocks in developed-market countries.

Russell 1000 Index measures the activity of the U.S. large-cap equity market.

Russell 2000 Index measures the activity of the U.S. small-cap equity market.

S&P Developed Large Midcap Index measures the performance of stocks representing the top 85% of float-adjusted market cap in each developed country.

Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. Positioning and holdings are subject to change. All information as of the date indicated. This information should not be relied upon by the reader as research or investment advice, (unless you have otherwise separately entered into a written agreement with SEI for the provision of investment advice) nor should it be construed as a recommendation to purchase or sell a security. The reader should consult with their financial professional for more information.

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