Where to ride out the volatility

Recent market volatility is leading many investors to exit stocks. For those that remain, the key question is: Where to hide? Russ Koesterich shares ideas, and opting for defensive sectors isn't one of them.

The one word that characterizes financial markets today: volatile.

Take last week’s gyrations. Stocks sold off aggressively for most of the week on concerns about plunging oil, falling U.S. earnings estimates, China and slowing global growth. Amid the selloff, Japanese, U.K. and French stocks all entered bear market territory, according to MSCI index data accessible via Bloomberg.

Then, markets rebounded strongly late in the week, thanks in part to dovish comments from the European Central Bank (ECB).

Indeed, volatility measures have spiked to multi-month highs lately, with 2016 experiencing the worst start to a year in market history, according to Bloomberg data. The volatility is leading many investors to exit stocks. For those that remain the key question becomes: Where to hide?

Under more normal conditions, the simple answer for U.S. investors, particularly when volatility is being driven by concerns over growth, is to re-allocate to more defensive, less economically sensitive parts of the U.S. market. Examples include certain sectors: utilities, consumer staples and often, telecommunications.

The traditional logic is that these sectors are less exposed to the pace of economic growth, and therefore, their earnings should hold up better in a downturn. However, this approach may not work this time around, because the volatility is largely being driven from outside the United States, i.e. China. Further complicating matters, after years of investors favoring these sectors for their dividends, many of these sectors are expensive. Finally, should market volatility begin to stabilize and interest rates climb a bit, these defensive stocks would be particularly vulnerable.

So, rather than focus on defensive sectors, investors may want to approach the current turmoil from a different perspective, and focus instead on these three investing strategies.

Consider minimum volatility funds

As their name implies, minimum volatility funds are explicitly designed to help mitigate the impact of market gyrations through a focus on less volatile securities. The approach, by design, is overweighting securities that exhibit less volatility. These are often companies with more stable earnings streams that may hold up better, on a relative basis, during market downturns.

Consider the quality theme

Investors may also want to consider adding quality to a portfolio, either through an Exchange Traded Fund (ETF) or active fund focused on companies with the following characteristics: earnings consistency, high return-on-equity (ROE) and low leverage. Historically, companies with these “quality” attributes have tended to perform relatively well during periods of rising volatility. In particular, quality companies have typically outperformed momentum names, a popular theme in recent years, when market volatility is elevated and rising.

Consider less traditional asset classes

Finally, investors may want to consider broadening their definition of stocks by moving “up the capital stack” toward preferred stocks. While they don’t provide the same upside potential as common stocks, U.S. preferred issues may provide less volatility.

Most preferred issues tend to be banks and other financial companies. Following massive regulatory changes in the financial sector, the U.S. banking sector is considerably less leveraged and arguably safer than it was pre-crisis. So, while more boring than they once were, U.S. financials may be well positioned to potentially provide a dividend stream.

To be sure, the above strategies aren’t likely to produce massive, double-digit returns. Investors looking for more aggressive profits probably need to test their nerves and try to time the market bottom. For the rest, a better approach may be seeking more modest returns with lower volatility, via a focus on portfolio construction, risk exposures and less traditional asset classes.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares ETF and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

The iShares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly.  Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.

Performance of companies in the financials sector may be adversely impacted by many factors, including, among others, government regulations, economic conditions, credit rating downgrades, changes in interest rates, and decreased liquidity in credit markets. There is no guarantee that any fund will pay dividends.

There can be no assurance that performance will be enhanced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”).  Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The information provided is not intended to be tax advice.  Investors should be urged to consult their tax professionals or financial advisors for more information regarding their specific tax situations.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by MSCI Inc., nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with MSCI Inc.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

USR-8336