Defining a New Framework for Equity Investing

Sharon Fay

Equity investing is facing a crisis of confidence. After several years of high volatility, disappointing returns and the failure of conventional diversification, the fear of equities is pervasive. After all, how can anyone rely on equities to meet future targets when extreme market turmoil can destroy years of careful planning in a heartbeat?

I think this question warrants a new way of thinking about equities. The traditional framework of investing by style and market capitalization is evolving toward an enhanced paradigm in which benchmark sensitivity and appetites for absolute risk will determine equity strategies (Display 1). Seen through this prism, there are more ways than ever to deliver long-term returns while managing short-term volatility in portfolios and allocations of portfolios.

This article is the first of several that present research we’ve done to help define a new framework for equity investing. We believe this framework can help align the diverse needs of clients with an increasing array of equity strategies available today.

By taking a closer look at what strategies worked during the market meltdown, we have developed a greater appreciation for the intricate fabric that defines the risk/return profile of different types of stocks. For example, the performance of certain types of stocks can vary over different time periods and in different market environments. And risk management is no longer just a defensive tool—effective risk budgeting can be used to generate better returns.

I believe that our framework reflects a more complete picture of equity investing, across a two-dimensional spectrum (Display 2). In the upper right quadrant, traditional style strategies offer the prospect of higher long-term returns, though absolute risk is high and performance is closely tied to the benchmark. Moving to the upper left-hand quadrant, strategies that provide more stability can help manage absolute risk by offering equity-like returns and alpha that is uncorrelated with traditional strategies.

Some investors may prefer to mitigate absolute risk by deviating more sharply from benchmarks. Higher benchmark sensitivity means that most of the return comes from market movements. In contrast, long/short strategies—in the lower left quadrant—are less benchmark-sensitive, so most of the return comes from stock selection. Long/short equities are also less correlated with traditional equities. Similarly, concentrated equities are less driven by benchmark movements, though their focus on a small number of stocks or a single industry may add to the risks.

The right combination of strategies really depends on a client’s needs and risk appetites. For example, institutional investors are grappling with pension fund deficits and new regulation that forces them to fund liabilities more often, making volatility more punishing. Individual investors are living longer than ever; they need strong equity returns, but the fear of stocks is pervasive.

We believe that our enhanced framework for equity investing can help investors overcome their fear of equities and provide an effective response to their needs, to navigate changing market conditions with confidence. In my next blog post, I’ll show how different types of equities have performed in different volatility environments.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Sharon Fay is Head of Equities at AllianceBernstein.

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