Downs and Ups: Managing Equity Volatility Goes Both Ways

January 23, 2024
5 min read

Defensive equity strategies that limit downside losses but lag too much in up-markets may be missing the mark. Is there another way to reduce volatility?

Market volatility can shake the resolve of even the most patient investors. But creating a portfolio that consistently delivers a smoother pattern of returns is challenging and requires an active strategy that focuses on both down and up markets.

That matters now more than ever. 

After two years of fighting inflation, the world’s central banks have pivoted by telegraphing monetary easing over the coming year. And while the global economy appears on track for a soft landing, investors are staring down several risks in 2024—including stubborn pockets of inflation, geopolitical instability and market concentration

Any of these risks could ratchet up market volatility, bolstering the case for defensive equity strategies. But while most low-volatility strategies can provide some measure of risk mitigation in down markets, many fall short during market rallies—mainly because they’re designed solely for defense. 

Is Minimum Volatility Really Low Risk?

Minimum-volatility (min-vol) strategies—often packaged as passive ETFs—are some of the most popular variants of defensive equity investing. These strategies systematically seek low-volatility stocks to aggregate into a portfolio. Typically, they include large allocations to traditional defensive sectors like utilities and consumer staples—bond proxies that can generate income and act as defensive stalwarts during market turbulence. 

But the past two years illustrate their shortcomings. 

When global stocks tumbled in 2022, the MSCI World Minimum Volatility Index (Min-Vol), a popular benchmark for the category, successfully cushioned declines (Display). But in 2023, global equities rallied nearly 24%, fueled disproportionately by a small number of US megacap stocks. During this time, the Min-Vol Index rose by just 7.4%—badly underperforming the market. Similar patterns were observed in the US. 

Minimum Volatility Index Has Lagged in Rising Markets
Returns shown for broad indices of global developed stocks and US stocks, versus the corresponding Minimum Volatility Index, in the falling market of 2022 and the rising market of 2023.

Past performance does not guarantee future results. 
As of December 31, 2023
Source: FactSet, MSCI, S&P and AllianceBernstein (AB)

This sizable performance gap in rising markets underscores the primary weakness of common min-vol strategies. Sure, they help buffer against down markets. But in rising markets, they often fail to deliver on client needs for capital growth. Over time, lopsided return patterns inflict a huge long-term cost on investment results. 

What’s needed is an active approach. 

Reducing Downside Losses While Capturing Gains

Building a resilient portfolio that both mitigates risk and captures the upside is no easy task, but it’s doable. In our view, the key is to look for quality stocks with stable trading patterns that can be purchased at reasonable valuations (what we call quality, stability and price, or QSP). 

Quality companies help drive upside participation because they have strong business models and recurring revenue streams that can withstand economic pressures through changing market environments. Stability can help curb losses in down markets, while a focus on attractive valuations can help investors steer clear of overvalued stocks—particularly important when traditional defensive sectors are in vogue and may see their prices driven up. 

But these components don’t work in a vacuum—they’re interdependent. After all, quality stocks won’t exhibit stability if they’re too expensive. If stock markets correct after a strong year, expensive names may be among the hardest hit, in our view. For that reason, we believe it’s important to select stocks at attractive valuations when constructing a defensive equity portfolio—especially in today’s market, when higher interest rates can induce valuation risk and when some of the most popular, high-flying technology stocks look pricey.

But can investors find defensive stocks at appealing valuations today? We think so. Our research shows that quality US stocks (companies with high return on assets) are fairly valued at the 60th percentile of their monthly history since 1990. Stocks with stability features and low prices trade near the low end of their 33-year valuation range (Display). So, by looking through a QSP lens, we think active investors can identify attractively valued stocks across a wider range of sectors than is typical for defensive portfolios.

QSP Stocks: Attractive Valuations Support Performance in Changing Markets
Current percentile rank of US stocks with select features of quality, stability and attractive prices are shown, based on monthly observations from 1990 to 2023.

Past performance does not guarantee future results. 
*Percentile rankings are based on monthly valuations (i.e., relative P/E of the first quintile for each factor vs. Russell 1000) from 1990 to 2023. Return on assets: last 12 months’ earnings divided by average total assets. Low beta: exponentially weighted beta with a one-year half-life over the last five years. Price to free cash flow: last 12 months’ cash flow from operations minus three-year average capital expenditures to market cap. 
As of December 31, 2023
Source: Refinitiv, Russell Investments, Thomson I/B/E/S and AB 

These types of stocks also have a solid track record in both falling and rising markets (Display). In 2022, our universe of global equities with strong QSP features fell by 8.4%—cushioning market declines similar to the Min-Vol. And last year, that same group of stocks advanced by 17.1%, capturing much more of the market’s gains than the Min-Vol. 

QSP Stocks Have Performed Well in Recent Rising and Falling Markets
Returns shown for a proprietary universe of stocks with features of quality, stability and attractive price are shown for 2022 and 2023, versus indices of global developed stocks and US stocks.

Past performance does not guarantee future results. 
QSP returns are for the quintile of developed global and US stocks with the highest strategic core edge. Strategic core edge is the expected return from a proprietary model combining a number of quality, stability and price factors, with a ratio of approximately one-third for each quality, stability and price component. 
As of December 31, 2023
Source: FactSet, MSCI, S&P and AB

No Contradiction Between Defense and Capital Growth

An active approach using thoughtful, fundamental research can uncover these often-overlooked names in a way that passive min-vol strategies can’t. That’s because passive strategies aren’t generally sensitive to valuations when allocating to low-volatility stocks. Moreover, passive portfolios can’t sift out and adjust the weights of individual stocks with high valuations. By contrast, active management can help identify businesses with hallmarks of quality and stability that aren’t fully appreciated by the market. Keeping valuation front and center provides a powerful antidote to potential market volatility—and a pathway to long-term gains. 

There’s no contradiction between positioning for long-term capital growth and striking a defensive posture, in our view. Portfolios that achieve these twin targets can help investors stay in equities through changing market conditions. 

At the start of the year, the world economy faces an especially wide range of potential outcomes. As a result, the trajectory of market returns is uncertain and could be volatile. An active approach focused on QSP stocks with a keen eye on valuation can provide investors with more levers to manage volatility in a year that could be full of surprises. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein.
The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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