BlackRock Investment Institute Report:
“Risk and Resilience: Patterns in Equities Returns”
Equity volatility is nothing new, yet patient investors are usually rewarded for staying the course. The latest BlackRock Investment Institute (BII) commentary, “Risk and Resilience: Patterns in Equities Returns,” explores the inherent risks in equities, details drivers of equities returns and flags complexities such as correlations and the paradox of the outperformance of low volatility strategies.
The BlackRock report highlights the rules of the waiting game and provides three key insights about the long-term patterns of equity returns:
• First, equities are volatile and have been throughout history
• Second, when it comes to equity investments, patience tends to pay off. Investors willing to hold equities for 10 years or more have a high chance of earning a positive real return
• Third, dig beneath the surface to understand how inflation, interest rates, growth, currencies, correlations and volatility can affect returns in surprising ways
Digging Beneath the Surface: What Drives Returns?
The BII commentators, Russ Koesterich, BlackRock’s Global Chief Investment Strategist, Ewen Cameron Watt, BII Chief Investment Strategist, and Edward Fishwick, Co-Head of BlackRock’s Quantatative Analysis Group, advise investors to dig beneath the surface to understand how factors such as inflation, interest rates, economic growth, currencies, correlations and volatility can drive returns.
Key drivers include:
• Inflation: Equities tend to do well when inflation is in the sweet spot of 2-3 percent or lower; as inflation starts to accelerate (especially over 4 percent), returns take a dive – but equities still outperform bonds
• Reinvested Dividends: Although they account for most of the equity returns in the very long run, market swings can easily swamp dividends in shorter time frames, where company fundamentals and financial conditions play a bigger role in driving equity returns
• Currencies: They have a surprisingly large impact on equity returns – especially in the short and medium term, and especially in emerging markets
• Inside the Index: Index averages can mask the fact that disparities between countries, sectors, and companies are huge – different exposures can translate into radically different returns
• Correlations: High correlations do not always mean similar returns – or low dispersion of returns
• The Curious Case of Low Beta: Low volatility strategies have outperformed more volatile equities in the new millennium – but they are vulnerable to rising interest rates, and may not be as lucrative in the period ahead.
Going for growth
The report also explores the relationship between economic growth and equity returns, and reveals the bottom line is that while growth is good for equities, it is often priced in fast, and can negatively affect equity returns, depending on the time horizon, the type of growth signal and the interplay with related factors such as inflation.
Volatility, bondification, low beta and what next for equities?
The report illustrates how equities have always been more volatile than bonds, but have generated enough returns to compensate investors for the anxiety. Risk-adjusted US equity returns (excess returns divided by volatility) consistently beat those of bonds from 1960 to 2000.
However, the trend reversed in the new millennium, with bonds recording superior risk-adjusted returns. In addition, low-volatility, or ‘low-beta’ equity strategies outperformed more volatile equities in the new millennium, too. This ‘bondification’ of parts of the equity market led to stark performance differences, with minimum-volatility counterparts of equity indices outperforming their peers with much lower volatility.
The report concludes by asking two questions: Why has taking risk not paid off?, and What happens when interest rates rise?
The authors suggest that the bondification of the equity market is part of the answer to why taking risk has not paid off in recent history. When interest rates decline (making it harder to earn attractive income from bonds), companies such as utilities with stable cash flows become more valuable as investors bid up the utility’s shares in a grab for yield, creating a self-fulfilling ‘low-risk, high return’ market. Set against this, when interest rates begin to rise again, the commentary suggests that low-beta plays could become a lot tougher – and less rewarding. Volatile assets could once again start compensating investors for the additional risk (and anxiety) they take on.
For a copy of “Risk and Resilience: Patterns in Equities Returns,” please click here
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