Andrew’s Angle

How to Prepare for an
Unpredictable 2019

Feb 11, 2019

The capacity of factor strategies appears large 

Market volatility and slowing growth have investors fearful of ongoing risk permeating through 2019.
So what’s a person to do? Here’s how to prepare.

The first month of 2019 has been remarkably reminiscent of how we began 2018.

Once again major equity markets have started the year with a rally, but the global economic backdrop has turned markedly gloomier. Negative sentiment from the World Economic Forum in Davos, concerns about Brexit, trade tensions, a U.S. government shutdown and an economic slowdown in China have all cast clouds over the future for markets.

Given this host of challenges, investors should expect a wider range of potential outcomes. In the face of such uncertainty, it’s important to keep long-term goals in mind, without losing sleep over the daily ups and downs of financial markets.

Investors should not live in fear of market unpredictability, instead they should build ballast into their portfolio.

Here’s three tips to help do just that:

  1. Bonds are back
    Investors should reassess their strategic asset allocation, and look at bonds through a factor lens to help ensure portfolios are truly diversified from equities.
  2. Turn down your equity risk
    Less volatile and higher quality securities may offer some protection in late cycle equity markets. Seek to reduce volatility and increase quality across the board.
  3. Embrace factor cyclicality
    Growth in factor investing strategies surged in 2018 and we believe will continue to accelerate. But investors should know that factor performance is cyclical. A tilting framework offers investors the opportunity to express tactical views and potentially enhance returns.

1.) Multiple sources of return provide ballast

The global economy has now shifted into a slower growth regime, acknowledged by heightened market volatility and the ensuing selloff in 2018 – the S&P 500 Index’s largest decline in a decade. Not surprisingly, investors are wary, and we see evidence of potential change afoot in the 2019 rebalance survey, showing more than half of BlackRock’s institutional clients plan to reduce allocations to equity markets.

The best way to adequately defend against these abrupt spikes in volatility, and potentially benefit from the subsequent return to moderation, is DIVERSIFICATION, DIVERSIFICATION, DIVERSIFICATION! Investors need multiple sources of return to drive portfolio outcomes.

As a factor investor, we can diversify across style factors—like value, momentum, quality, and minimum volatility—within an asset class like equities. We can also diversify using macro factors across asset classes. Equities are largely exposed to risks related to the strength of economic growth, while U.S. treasuries are driven by real interest rates and inflation.

In particular, bonds provide a way investors can diversify away from economic growth towards other factors. As market volatility increased in the fourth quarter of 2018, investors were again reminded of the importance of bonds in a diversified portfolio context. But we can get smarter about the types of bonds we hold as well, and use a factor framework to construct smart bond portfolios based on factors that drive bond performance. This allows investors to make deliberate choices on factor exposures such as interest rate risk or credit risk to drive the performance of their fixed income portfolio.

2.) Minimum volatility and quality offer equity resilience

Our research suggests that high quality companies and low volatility strategies perform well at later points in the business cycle. The quality factor benefits from companies that exhibit strong free cash flow, solid balance sheets and proven business models that are positioned to withstand temporary downturns. Volatility spikes associated with stock market crises can come on unpredictably, and the quality factor may help to minimize these drawdowns across a variety of equity market meltdowns, such as the China Market Crash (2015) and the Volatility Spike (2018) shown in the table below.

MSCI USA Sector Neutral Quality
Index Excess Performance vs. S&P 500 Index

QualityS&P 500Difference

China Market Crash (Jun 2015 – Aug 2015)

-5.46%

-5.92%

0.46%

Volatility Spike (Feb 2018 – Mar 2018)

-4.08%

-6.13%

2.05%

Source: BlackRock. Morningstar data as of 9/30/18. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

In addition to quality, defensive positioning using factors can include increased exposure to minimum volatility strategies that seek to deliver market like returns at lower levels of risk. Like quality, minimum volatility stocks have tended to outperform during market slowdowns. In a year like 2018, minimum volatility proved its merit, exhibiting a reduced correlation to the broader market and delivered a positive return, while broader US markets suffered sharp declines.

Minimum volatility's resilience

Minimum Volatility's Resilience

 

Source: MSCI and Morningstar Direct as of 12/31/18. MorningStar Category: US Large Blend. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

Tilting portfolios towards defensive factors may help protect against further downside risks as we enter a potentially more volatile 2019. However, remember diversification, which still offers the best potential to hold factors which could experience positive returns to help offset losses during market volatility. The core of diversification, with a tilt to defensive factors, helps establish portfolio resilience and offers the potential to reward investors in 2019.

3.) Factor tilting goes mainstream

The upside to market volatility is that securities can become cheaper, creating attractive buying opportunities. The same goes for factors. Investors have long debated when to rotate out of growth and into value for example (a topic I have covered on a previous post) which is simply a form of factor rotation or tilting in a portfolio (albeit with an incomplete set of tools). While making timing decisions is anything but “simple,” it can be done by sophisticated investors leveraging a number of data points like relative valuations, market price trends, and economic signals. In fact, we have managed a factor rotation model that does this for institutional clients globally for a number of years. The secret to success is factor tilting, not timing.

Increasingly, our institutional clients have expressed interest in augmenting, or replacing outright, their historical sector rotation strategies with factors. The potential benefits of leveraging rewarded drivers of returns with portfolios that exhibit lower correlations to the broader market are clear. Investors have realized that you can use forward looking insights to illuminate opportunities to tilt toward a factor or set of factors that have greater near-term return potential, just like they have used sectors in the past.

Factor tilting, rather than short-term in-and-out timing, can balance opportunities to seek improved returns, while maintaining the potential long-term benefits of a well-diversified factor portfolio. Investors can use forward-looking insights across valuations, relative strength, dispersion and the current economic regime to illuminate potentially rewarded factors. If you are repositioning your portfolio, and aren’t leveraging the benefits of style factors, you may be missing out on potential sources of excess return. Our quarterly factor outlook provides our views on the relative strength and opportunity set within each of the five factors.

Factor strategies are poised for growth

iShares factor ETFs have seen an average of 20% annual organic growth over the past five years, as annual flows have more than doubled from 2013 to $22 billion in 2018. Factor ETFs account for 10% of the flows into global exchange traded products and accounted for 9% of the AUM of all exchange traded products at the end of 2018.We believe that’s only going to increase, while many traditional areas of asset management are likely to continue shrinking. Not so long ago, only sophisticated investors could tap factor investing strategies, or these exposures were embedded in (usually high cost) active funds. Factor ETFs are democratizing access to these academically based and economically intuitive drivers of return. I foresee continued expansion in the range of factor solutions available to investors of all types.

Rapid technology advancements will continue to evolve factor investing. At BlackRock, we make strides daily to improve the forensic technology available to investors to better identify and visualize factor exposures. Our factor technology tools include the Factor Box and Factor Performance Tool:

1.)  Factor box – where investors can enter tickers and view the factor exposures of various funds

2.)  Factor performance tool – where advisors can review how factors have performed through economic cycles, market shocks and other time periods

In 2019, we’ll further improve these tools to further power our factor investment decisions. We’ll also offer our clients new ways to visualize their factor exposures and measure the risks in their portfolios.

While 2019 may be challenging, I’m eager for more investors to consider taking advantage of factor investing as a means to better understand the drivers of return in their portfolio. If factors aren’t playing a role in your portfolio this year, I encourage you to dig deeper into the resilience and returns that factor-based strategies can offer.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro ...