Building Portfolio Resilience in the Face of Volatility

One of the most misunderstood concepts in investing is that volatility can surface without warning. While the 2019 market rebound has undone much of the damage from 2018’s year-end drubbing, the dramatic sell-off is a key reminder that portfolio management, specifically the importance of having defensive exposures, is key to a resilient portfolio.

The sell-off from October 3rd to December 24th dragged the S&P 500 Index down by 20 per cent and the Russell Small-Cap Index by more than 24 per cent (Source: Bloomberg, figures in USD). This was driven primarily by fears of continued rate hikes by the Federal Reserve, as well as concerns regarding a slowdown in corporate earnings global growth more generally.

These large drawdowns are a far cry from the relatively low volatility environment markets have experienced in recent years, which drove investors to seek exposures to pro-cyclical market areas such as momentum stocks or high yield credit. As investors adjust to a lower growth paradigm, they begin to consider exposures that either offer protection through limited downside, such as minimum volatility strategies, or those of higher quality - across both equities and bonds. 

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Indeed, investors are taking notice of the importance of defensive positioning. Even with the rebound in stocks this year, our research shows that flows into defensive exchange-traded products (ETPs) are outpacing flows into all other products as a percentage of assets under management (see chart one).

United States listed fixed income Exchange-Traded Funds (ETFs) have garnered nearly twice as much as equity flows year to date. Minimum volatility strategies are the most popular amongst factor-based strategies, gaining US$5.78 billion, while momentum has seen nearly US$0.6 billion in outflows. Having selective risk exposures at the core of a portfolio will potentially help investors maintain resilience, and ETFs seem to be a cost-effective way to enter such defensive positions.

Chart 1: Looking for defence: US listed exchange traded product flows

Source: Markit, BlackRock, as of 19 March, 2019


Constructing resilient portfolios with ETFs

Keeping risk front of mind when determining the asset allocation of a portfolio is key towards potentially minimising losses in the face of volatility. This may start with a ‘core-satellite’ strategy, which refers to a portfolio with a broad (core) exposure to an asset class while enabling the flexibility to adjust to current market conditions with other (satellite) investment exposures.

According to a Brinson, Hood & Beebower study, asset allocation accounts for 94 per cent of the variation in portfolio returns. This is not to diminish the importance of market timing and security selection in achieving alpha, but rather to highlight the dominant influence of asset allocation on portfolio outcomes. 

A common method to creating a core holding is through ETFs, which can provide broad-based exposures to different countries and sectors. Trading like single stocks but having access to a comprehensive world of investment options, ETFs are a cost-effective way to gain exposure to a diversified portfolio of securities and hence help to spread idiosyncratic risk. With over 7,000 ETPs globally across markets and asset classes (as of 2018), investors are spoilt for choice.

An alternate method to portfolio construction is to build portfolios with respect to factors, as opposed to asset classes, which can be used at either the core of your portfolio, or otherwise as satellites. This is often termed as factor-based investing. In its simplest form, factor-based investing is the identification of quantifiable characteristics of assets that relate to risk and return, and subsequently implementing rules-based frameworks for the portfolio that either capture or avoid these characteristics. The most well-known style factors include Quality, Minimum

Volatility, Size, Momentum and Value

Factor-based investing is possible through ETFs, also known as Smart Beta strategies. Combining elements of both traditional passive and active investing, smart beta strategies combine the diversification benefits of passive investments with the benefits of style-tilts at a fraction of the cost of active management. However, when uncertainty surrounding volatility are present and rising, quality and minimum volatility exposures are the most popular style tilts for defensive strategies. This is because securities with these exposures tend to outperform in tumultuous periods, highlighting their importance in building portfolio resilience. 

Quality-Focused Strategies

Quality typically connotes some combination of high profitability, low debt-to-equity and earnings consistency. In aggregate, this style has historically delivered a return premium, i.e. the opportunity to outperform a broad benchmark over the long term. As seen below in chart two, companies in the MSCI Quality Index have outperformed the broader market, and this outperformance becomes more pronounced in months when the VIX Index rises.

With quality performing best during slowdown and contraction phases, it may be worth considering assets that possess these characteristics, given the global economic slowdown. As a defensive measure, this factor is not limited to equities, but is also accessible through fixed income securities.

Investors concerned with slowing growth or geopolitical turmoil may want to consider longer duration Treasuries (10 years or longer) as historically, these have offered some buffer for portfolios in market downturns, as well as a chance to potentially pick up some extra yield relative to short-dated bonds. 

Traditionally, there is an inverse relationship between equity and government bond returns, and we see this negative correlation being sustained in this late-cycle period. With such deepening negative correlations between debt and equity securities, the role of bonds as a powerful diversification tool is elevated, particularly in balancing risk and reward in portfolios.

iShares has an ETF – the iShares Treasury ETF (IGB) – that provides exposure to Australian Treasury bonds, and therefore incorporating this into the core of a portfolio may also build portfolio resilience. 

Chart 2: MSCI World v MSCI World Quality

Source: Bloomberg, as of 12 April, 2019

What are Minimum Volatility Strategies?

Minimum volatility strategies have historically reduced risk in down markets compared to the broader market – with Q4 2018 being no exception.

We can observe the benefit of these minimum volatility exposures when looking at the daily returns of the iShares Edge MSCI Australia Minimum Volatility ETF (MVOL) versus its parent index, the MSCI Australia Investable Market Index (IMI), in chart three. With MVOL minimising losses when the broad market declines, we believe a Minimum Volatility strategy can be used to replace and act as a core holding within a strategic asset allocation, being a possible way to reduce risk

As minimum volatility strategies have historically provided resilience during down markets, they have helped investors remain invested during periods of market stress and uncertainty.

Remember, humans experience the woes of losses more severely than the joys of gains (termed ‘loss aversion’), making lower downside capture an effective way to keep investors in the market and on-track with their long-term goals.

For this reason, more stable equity allocations to Minimum Volatility strategies such as MVOL and WVOL can be a powerful core holding within portfolios. With continual political and economic concerns potentially fuelling higher volatility, investors would be prudent to consider deploying a Minimum Volatility strategy within their portfolios.

Chart 3: Minimum volatility strategies are key for portfolio resilience

Source: Bloomberg, as of 12 April, 2019


Over the long term, creating a buffer from market downturn – known as ‘downside protection’ – can add value to a portfolio.

Given the sporadic nature of market fluctuations, a disciplined asset allocation approach that involves a diversified portfolio of securities across asset classes, sectors and countries should include defensive assets to focus on long-term goals. This can be achieved through factor-based investing with a focus on minimum volatility or quality-focused strategies. This avoids impulsive reactions to short-term volatility, particularly as market complacency rises and the US enters its late-cycle phase of the economy.

Portfolio resilience is now imperative, and utilising defensive strategies that can help diversify away a portfolio’s unsystematic risk but potentially minimise downside risk can be implemented through Smart-Beta ETFs. Whether it be minimum volatility equity strategies or utilising Treasuries, the importance of downside protection has heightened given the recent bouts of volatility in 2018.   

Christian Obrist is head of BlackRock's iShares business in Australasia.

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