The De-risking Benefits of Low Vol Equities
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When it comes to reducing equity risk on a standalone basis, as well as total portfolio risk in a balanced portfolio, low volatility equities – i.e., the stocks of non-cyclical companies with stable earnings whose prices aren't volatile - can play a strategic role. Investing in low volatility stocks can be an effective way for investors to de-risk their portfolios while maintaining equity exposure, even in the presence of other correlated, low-risk assets.
By substituting low volatility equities for capitalization-weighted equities (i.e., broad-based stock indices weighted by market capitalization), in whole or in part, investors can potentially achieve comparable returns over a full investment cycle with a significant reduction in total portfolio risk – a phenomenon that tends to be persistent across market, volatility and correlation regimes.
This is the core argument of a new in-depth article by TD Asset Management Inc. called De-risking Portfolios with Low Volatility Equities.
According to the article, one benefit of low vol equities is that they can potentially help when diversification fails. The traditional 60/40 portfolio – which includes a 60% allocation to stocks and a 40% allocation to bonds in an effort to balance the growth potential of stocks over the long run with the defensive properties of bonds – is built on the premise that there is a persistent negative correlation between bonds and equities. When equities go up, bonds go down, and vice versa.
But when that relationship breaks down, as it did in 2022, so do the purported benefits of diversification. The 2022 experience is a reminder that while diversifying across asset classes is necessary to reduce risk, it may not always be sufficient.
Another de-risking property of low vol equities is that they can help weather market crashes, the article notes. As a standalone strategy, low volatility equities have proved remarkably resilient, consistently lowering risk and downside participation across a variety of market regimes. Low volatility equities outperformed other equity styles during the worst crises of the last quarter century: the Asian financial crisis in 1998, the dot com crash of the early 2000s, the global financial crisis which began in 2007, the European debt crisis which started in 2009, the COVID-19 crash of 2020 and the 2022 economic slowdown. While low volatility was not the top performer in every one of these crises, it ranked among the best.
Yet another risk-reducing property of low volatility equities is that they free up room in investors' risk budget, allowing them to hold more equities or other return-seeking assets. The article demonstrates this by examining two classic 60/40 portfolios, one using capitalization-weighted equities and the other low volatility equities.
For more detail, read the full article
The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.
Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS.
Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS.
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