Northern Trust’s Hunstad On Investing In Quality When Market Risks Increase

Dr. Michael Hunstad, Deputy Chief Investment Officer and Chief Investment Officer for Global Equities at Northern Trust Asset Management, joined Keith Black, Managing Director of RIA Channel, to discuss investing in quality stocks during increasing episodes of market volatility.   

Traditionally, investors have controlled portfolio risk through asset allocation, especially by decreasing equity exposure in favor of fixed income allocations. Today, it is less effective to control risk in this manner due to increasing volatility of both equity and fixed income markets as well as the increasing correlation between the two markets.1

Another way to control risk is to reduce risk within the equity and fixed income allocations, such as through an investment in lower volatility, higher quality equities.  While low beta investing is likely to reduce exposure to both the upside and downside of equity markets, investing in quality stocks seeks to maintain exposure to market upside while reducing exposure to market downside returns.

Dr. Hunstad explains that the frequency and severity of volatility shocks has been increasing in both equity and fixed income markets, with more downside tail risk recently experienced in both the equity and fixed income markets.  In addition to rising volatility in both markets, the correlation between equity and fixed income returns is also increasing, which leads to reduced diversification benefits and greater portfolio tail risk.2

Dr. Hunstad believes that this increase in volatility and correlation are due to structural changes in market behavior which is unlikely to reverse anytime soon. There are three potential explanations for these structural changes.  First, increased levels of volatility selling by institutional investors can exacerbate volatility in market declines when investors cover short volatility positions to control risk.  Second, algorithmic traders are an increasingly large part of equity market volume, but may stop trading and reduce market liquidity as volatility increases. 

Perhaps the most important long-term market change is that institutional investors have moved from 5% to 50% allocations to passive equity over the last twenty years, making the market more inelastic2.  In an inelastic market, it now takes a smaller dollar volume today to move the stock market 1% today than in the past.  As the number of institutional investors and active managers involved in equity analysis and price discovery process declines, Dr. Hunstad explains that retail investors are now exerting more influence over setting stock prices. 

To Learn more:

Why Value, Dividend, and Low Volatility Equities Could Outperform in 2023

1 Instances of VIX daily increase greater than 5 points: 5 from 2000-2007 vs. 69 from 2008-2022 for equity markets, 15 from 2000-2007 vs. 58 from 2008-2022 for fixed income markets.

2 Source: Northern Trust Asset Management, Bloomberg, Morningstar. Elasticity is measured using SPX as average daily return divided by daily volume.


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