Quality as a Hedge Against Rising Volatility

While momentum stocks have prevailed since 2016, is quality about to have its day? Possibly, if volatility continues to rise, as Russ discusses.

Growth stocks’ extended dominance over value has captured the headlines of late. That said, since the end of 2016 it has really been about momentum. While investors have focused on earnings growth, an even better approach would have been to simply buy the stocks rising the fastest, otherwise known as momentum investing.

Year-to-date, momentum continues to outperform the rest of the market, but the regime may be shifting towards a different equity style. As I discussed last February, when uncertainty and volatility are rising, quality tends to outperform. As trade issues have escalated, this has once again proved the case. Since the early summer, companies in the MSCI Quality Index have outperformed other investment styles as well as the broader market (see Chart 1).

equity style performanceFinal

To review, quality companies generally include firms with high return-on-equity (ROE), earnings consistency and low leverage. These characteristics suggest safety, which investors put a premium on when volatility is moving higher.

While volatility remains low by historic standards, it is on the rise. Last year volatility was anemic, with the VIX Index averaging just above 11, well below its long-term average of 20. However, during the past six months the VIX has averaged close to 15, a 34% increase. Assuming volatility continues to normalize, historically this has been the type of market when quality has been the most valuable.