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Retirement Planning > Retirement Investing > Income Investing

How Low-Volatility Stocks Can Enhance a 60/40 Retirement Portfolio

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What You Need to Know

  • Higher volatility and lower returns mean the need for different investment strategies.
  • Using a low-volatility strategy can improve returns and lower risk.
  • This strategy may be especially useful for those clients in or nearing retirement.

Saving and investing for retirement requires clients to be steadfast in their contributions and stay the course when market volatility tests even the most patient of investors.

Unfortunately, volatility has been increasing in frequency and magnitude and return expectations are projected to be lower in the future than over the last five years.

Clients, therefore, will need to save more or invest differently to reach their retirement goals. With this backdrop, it may be prudent to consider incorporating an equity strategy for clients that can potentially deliver stronger, more intentional returns and lower overall risk to address these investing challenges.

60/40 Challenge

Returns for a traditional 60% equity and 40% fixed income portfolio are expected to be muted moving forward. Northern Trust Asset Management projects U.S. stock returns to average 4.7% annually over the next five years, versus the 10.8% growth they have averaged annually over the last five years.

Much has been discussed regarding diversifying fixed income strategies to boost return and lower interest rate risk in a 60/40 portfolio, but what about the equity portion of one’s allocation?

Increasing equity allocations to lift expected portfolio returns may feel a bit precarious for many investors nearing or in retirement, especially with volatility increasing. It might sound counterintuitive, but one way to mitigate risk and market volatility is through the use of a quality low volatility (QLV) strategy.

Benefits of QLV

Low-volatility stocks tend to experience a narrower range of returns than the market as a whole. Further, our research shows that low-volatility stocks have historically outperformed the broad market on a risk-adjusted basis.

By investing in such stocks, clients are less likely to endure severe market drawdowns or declines and are less likely to panic and abandon long-term investment goals when markets are in turmoil.

Our research also shows that investing in companies that are of the highest quality — those with strong cash flows, profitability and management efficiency — may further mitigate market declines and potentially improve performance.

Enhancing 60/40 With QLV

In the illustration below, we examine the comparison of a 60/40 portfolio versus that of a “de-risking 1.0” portfolio, where equity allocations are reduced by 10% in favor of bonds, to demonstrate what a traditional risk reduction strategy does to portfolio returns.

The 1.0 portfolio has a significantly lower standard deviation, or risk, than a 60/40 baseline portfolio, however returns are comparable (5.63% vs. 5.49%). In the future, we expect this risk-return tradeoff to be much greater, with the 1.0 portfolio returning less than it has historically given the current low interest rate environment.

With this in mind, clients may need advisors to look at creative solutions within their equity allocations to achieve higher results, without necessarily increasing their risk profile.

Looking at returns over the last 13 years ending Dec. 31, 2020 (the common lifespan of NTAM’s QLV strategies), let’s see how the addition of QLV could improve portfolio outcomes when used in place of the MSCI All Country World (ACWI) index.

The 2.0 scenario stands on its own merits displaying superior returns, lower risk, higher Sharpe ratio, and lower max drawdown compared to the 1.0 portfolio. However, as we have discussed, investors near or in retirement will likely need higher equity levels to achieve similar results moving forward, but may be wary of holding a larger equity allocation.

To address this concern, consider the “de-risking 2.1” scenario which captures the same overall risk as a 50/50 “1.0” portfolio (8.84%), but holds 16% more equities, and achieves an excess return over the 1.0 portfolio of 1.49% annually (6.97% vs 5.49%).

Depending on what level of return or risk a client is seeking to achieve, a case can be made for either the 2.0 or 2.1 scenario that improves risk-adjusted results versus the baseline 60/40 portfolio.

While past performance is no guarantee of future performance, we feel clients have options to take risk more efficiently to combat the expected low return environment. While a simple balanced portfolio may have worked in the past, the low-return environment may challenge its viability in the years ahead.

Incorporating a QLV strategy into a portfolio will allow clients to be properly compensated for the risk they are taking and potentially increase returns, while managing market volatility.

Paul Kubasiak is a retirement specialist with Northern Trust Asset Management, a global investment manager with$1.1T AUM that helps investors navigate changing market environments.

(Northern Trust Asset Management offers products tied to the strategy highlighted in this article.)


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