By Kent Hargis, Sammy Suzuki and Christopher Marx

The market convulsions of the past months have many institutional investors thinking twice about their allocations to equities. But there’s a way to stay the course in equities without abandoning comfort zones: consider strategies with built-in shock absorbers.

Markets have been growing more unruly since last Autumn, (Chart below, left) as interlocking issues surrounding the collapse in oil prices, slowing growth in China and shifting US monetary policy raise doubts about the vitality of the global economy. As things stand, we are unconvinced that China’s transition and the disruptions in the energy market will significantly erode global economic conditions. The US consumer appears strong, job growth is accelerating and conditions in Europe and Japan look steady if uninspiring. We think current conditions are more consistent with a transient mid-cycle correction than a prolonged recession or credit crisis that will lead to an extended bear market as in 2008.

It is true that spikes in volatility tend to presage future turbulence (Chart above, right). When the ride is so jolting, investors may be tempted to rush for the exits. But history teaches that such responses (indeed, most efforts at market timing) have proven costly. Investors risk locking in losses, and missing out on the market’s eventual recovery. We don’t think it’s time to reduce exposure to equities.

Passives can leave investors overly exposed  

Many equity investors often tackle the risk issue by defaulting to traditional passive cap-weighted, index-tracking strategies and ETFs. But purely passive approaches are not wholly without risk. These types of strategies are particularly risky at this time.

While they may address concerns about relative risk, passive approaches can’t help investors mitigate absolute risk when markets decline. In fact, most passive strategies in this arena screen strictly for low beta, with no consideration of valuation or return potential. This can leave investors overly exposed to pricier subsets of stocks, industries or countries.

After multi-year outperformance, for example, lower-beta stocks are trading at some of their highest valuations of the past 25 years (Display, right bar). Some would say the MSCI Minimum Volatility Index, the most commonly used proxy for low-beta stocks, has become the “safety at any price” benchmark. It currently trades at a 32% premium to the MSCI World Index based on 12-month forward earnings and a 26% premium based on free cash flow.

The index is also concentrated in many “bond proxy” sectors, such as utilities, which adds unintended interest-rate sensitivity. And going with the passive flow could mean forgoing any potential for future upside in returns when investors need it most—in an era when broad market performance is likely to be more subdued.

In fact, low volatility equities come in many shapes and sizes. Notably, many cash-generative companies, with good business models are still trading at reasonable valuations (Display, left bar). This is precisely why we believe a multifaceted, active approach is the way to go when investing in this space.

Active Can Finesse

An active strategy can adjust exposures depending on insights into current fundamental attractiveness and risk, even pivoting into sectors not typically associated with low volatility. For instance, we’ve found attractive opportunities in software companies with large installed bases and low capital needs. Within healthcare, even after the strong biotech-led outperformance last year, there are many large, diversified pharmaceutical companies with strong and stable cash flows that are still selling at discounts to the market.

The equity market’s recent turbulence has been unnerving. It also comes with the territory but, by actively trading off between quality and stability, and remaining sensitive to valuation, it is possible to build a portfolio that can weather future bouts of volatility through a variety of environments. That’s particularly important given where we are in the investment and rate cycle. A smoother journey that’s easier on the nerves can help keep institutional investors on course when turbulence strikes and improve their odds of getting to their desired investment destination.

Kent Hargis is Portfolio Manager—Strategic Core Equities at AB, Sammy Suzuki is Portfolio Manager—Strategic Core Equities at AB, and Christopher W. Marx, Portfolio Manager—Equities at AB