The Australian share market’s strong run during the last two-and-a-half years is causing cautious investors to become more wary about the possibility of downside risks, global asset manager AllianceBernstein said today.
And the market’s unusually low volatility is prompting them to wonder whether one of the biggest risks could be complacency—or a reluctance to ask, when stocks are performing well, “What could go wrong?”
In a research paper, “Australian Equities and the Volatility Dilemma”, the firm notes that the volatility index or VIX—a measure of expected volatility based on the pricing of 30-day stock index options—is often seen as a “fear indicator” when it’s high and a “complacency indicator” when it’s low.
It also notes a history of inverse correlation between the S&P/ASX 200 VIX and the underlying S&P/ASX 200 Accumulation Index: that is, Australian equities typically fall when the VIX rises and vice-versa.
“There appears to be enough prima facie evidence, based on the current differential between the equities and VIX indices in Australia, for investors to take steps to guard against complacency, at the very least,” says the research paper.
One solution for investors wishing to take such steps may be to increase their portfolio exposure to low- volatility or low-beta equities. According to the paper, while low-beta stocks can struggle to keep up in bull markets, they typically provide more downside protection when markets are in retreat.
In fact, research has shown that a portfolio of low-volatility stocks will tend to outperform high-volatility portfolios on a risk adjusted basis over time—a phenomenon known as the “low volatility anomaly”.
“A strategy that combines low-beta and high-quality stocks at reasonable valuations with a focus on absolute returns would be a reasonable option for investors who want to remain exposed to the growth potential of equities but are concerned about the market’s apparent complacency,” says the paper.
“These types of strategies can be particularly appealing for retirees (or those close to retirement), for defined-benefit superannuation schemes and insurers.”
Click here to download the research paper.
