We have previously written about the heightened potential for increased volatility and corrections in global equity markets - Equity market complacency is over - and with the numbers now in for March, this potential appears to have become a reality thus far in 2018.
March was another rough month for risk assets, in particular for equity markets. US equity markets experienced regular daily swings of 2%, and the NASDAQ saw four consecutive days of moves of at least 2% - something not seen since 2011.
With this trend, in our opinion, likely to continue through much of 2018, investors may do well to consider a defensive strategy within their global equity portfolio allocation. One way to potentially achieve this would be to employ a ‘quality and dividend yield' equity factor strategy.
Avoiding the yield ‘trap'
Investors can benefit from the combination of quality and dividend yield factors through a systematic investment style to capture the excess returns of high-quality stocks over low-quality stocks while avoiding the yield trap.
Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage (debt-to-equity ratio), but also because their superior profitability (a company's ability to generate earnings as compared to its expenses) and lower earnings variability suggest they are aptly managed and can quickly adapt to changes.
Momentum can be more susceptible to market downturns
While the Momentum strategy has outperformed Value and Quality strategies, it also exhibited the highest annualised volatility (16%), and can be more susceptible to market downturns. For instance, during the Global Financial Crisis, the MSCI USA Momentum Index lost 52% from October 2007 to February 2009, compared with 48% for the broad market (S&P 500 Index) and 39% for MSCI USA Select Quality Yield Index (SQY) Index.
Source: MSCI, Bloomberg, BMO Global Asset Management (December 1999-February 2018).
Quality provides diversification for multi-factor portfolios
In the table below, we have illustrated the relationships between various pure factor portfolios over the long term. The returns of two Quality-based portfolios, namely profitability and low earnings variability, have exhibited a low or negative relationship with Value and Momentum strategies.
| Value | Momentum | Profitability | Earnings Variability | |
| Value | 1.0 | |||
| Momentum | -0.3 | 1.0 | ||
| Profitability | -0.5 | 0.3 | 1 | |
| Earnings Variability | 0.1 | 0.2 | 0.5 | 1.0 |
Source: BMO Global Asset Management, Bloomberg, Correlations of daily Returns (31.12.1999 to 05.03.2018).
The quality screening has been successful to increase yield and dampen volatility when added to other factor portfolios. The graph below illustrates the risk-adjusted return profiles of a pure Quality, pure Value and multi-factor equity portfolio.
Source: MSCI, Bloomberg, BMO Global Asset Management December 1999-February 2018. MSCI USA Factor Indices.
Past performance should not be seen as an indication of future performance.
With the already-increased level of volatility in 2018 likely, we believe, to persist throughout the year, it could benefit investors to take another look at their equity allocation and consider how adding a ‘quality and dividend yield' equity factor element could help to reduce volatility but still capture some yield.
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