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Rethinking Equity Investment

Market turmoil means traditional frameworks don't cut it.

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roller coasterIt’s been another year of heightened market volatility, and the crisis of confidence in equity investing has deepened. The fear of stocks is pervasive after several years of turbulence, disappointing returns and the failure of conventional diversification. After all, how can anyone rely on equities to meet future targets when extreme market turmoil can destroy years of careful planning in a heartbeat?

Perhaps it’s time to change the way we think about equities. In our view, the traditional framework of investing by style and market capitalization is evolving toward an enhanced paradigm in which benchmark sensitivity and appetites for absolute risk will determine equity strategies. Seen through this prism, there are more ways than ever to deliver long-term returns while managing short-term volatility in portfolios and collections of portfolios.

A better investing framework to reflect a more complete picture of equity investing is across a two-dimensional spectrum (Figure 1). In the upper right quadrant, traditional style strategies offer the prospect of higher long-term returns, though absolute risk is high and performance is closely tied to the benchmark. In the upper left-hand quadrant, stability strategies can help manage absolute risk by offering equity-like returns and alpha that is uncorrelated with traditional equity strategies.

Figure 1 (click on image to enlarge)

Equity paper 1

Some investors may prefer to mitigate absolute risk by deviating more sharply from benchmarks, using long/short strategies, which are also less correlated with traditional equities. Similarly, concentrated equities are less driven by benchmark movements, though their focus on a small number of stocks or a single industry may increase risk.

What Works in Tough Markets?

To understand how different equities can complement each other, we analyzed the performance of traditional style and stability stocks in different market environments over four decades. Our research found that when volatility was falling or flat, value stocks (low price/book value) and growth stocks (high earnings revisions) outperformed a global universe of stocks by a healthy margin. But rising volatility significantly muted the premium of value and growth stocks. In contrast, stocks with stability factors—such as high dividend yields or low volatility—thrived in volatile environments.

Although value and growth stocks simultaneously collapsed between 2008 and 2011, we still have conviction in their long-term efficacy, as both are rooted in human behavioral trends. But during periods when traditional style is challenged, keeping part of an allocation in stability equities offers an added dimension of protection from volatility.

To test this, we looked at a universe of stability and long/short portfolios during recent crises. For example, when the euro crisis escalated in the third quarter of 2011, the MSCI World index plunged by 17%, while global low volatility equities fell by just 8% and an allocation including a combination of stability and long/short equities fell by 10%. While you can’t completely escape unscathed in such an environment, mitigating the declines makes it much easier for an investor to recoup losses when markets recover.

Getting More from Managing Risk

But protecting equity investments from turbulence is only part of the story. Risk management is no longer just a defensive tool—effective risk budgeting can be used to generate better returns.

Our simulations found that the risk/reward profile of an equity allocation can be improved significantly by shifting a portion from traditional large and small-cap equity strategies into a combination of equity income, low-volatility and market neutral equities (ie, portfolios with less exposure to directional equity-market moves). Such a portfolio would enjoy lower volatility, a slight increase in return, and a significant improvement in the Sharpe ratio, meaning a smoother ride through volatile markets.

The right combination of equities really depends on an investor’s specific needs and risk appetite. But we believe that an enhanced framework for equity investing can help investors regain confidence in equities and navigate challenging market conditions effectively, by broadening exposure to a combination of stocks tailored for different risk appetites and goals.

Sharon E. Fay, CFA, is Head of equities and CIO – Global Value with AllianceBernstein.

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