When investors struggle with high uncertainty or significant volatility, they often are searching for ways to buttress their portfolios against distress. They could boost their bond allocations at the expense of stocks, but reducing exposure to equities after large selloffs can damage long-term performance.[1] How can investors avoid the urge to sell during down markets to participate in long-term equity-market performance while mitigating risk in their portfolios?

We think anchoring to strong fundamentals is a good start. This means owning companies with plenty of cash flow, high returns on capital, and management that avoids overstretching the balance sheet with empire building. These strong fundamentals define quality — among the so-called equity factors (others include low volatility, which we’ll discuss later, as well as value, momentum, and dividend payers)  that academic studies and our research show has  outperformed the broad equity market over time.[2]

Defining Quality

Quality is a challenging equity factor to define. Investment managers who use quality to build their active equity strategies have their proprietary definitions. As an example of metrics we use, a high quality company within the technology sector looks like this:

• Annual asset growth: 3%. Low or negative asset growth means the company’s executives are keeping their empire building — which can load companies with debt — at bay.
  
  
• Return on invested capital: 60%. Executives are doing a good job turning their capital into profit.
  
  
• Free cash flow as a percent of sales: 25%. The company is profitable from a cash flow basis and able to turn revenues into free cash flow by managing costs.

In comparison, an example of a company with weak quality characteristics had 15% annual asset growth, 9.7% return on invested capital and 3.7% free cash flow as a percentage of sales.

A History of Limiting Downside and Strong Upside Participation

Because of strong fundamentals, quality stocks have delivered benefits to investors during volatile markets often associated with market declines. Our research shows that on average, when markets have fallen, high quality stocks held up better — limiting losses to 87% of monthly U.S. equity market downturns. Quality also participated in market rallies, capturing 96% of monthly market gains on average.[3]

Quality has historically captured more in upside markets than it has lost during downside markets, making it an important diversifier for long-term performance. Further, Exhibit 1 shows that quality has outperformed the broad market with slightly less volatility. This reinforces our belief that quality can serve portfolios well throughout the cycle, allowing investors to be modestly defensive while still keeping up during the rallies. 

Quality Plus Low Volatility Can Amplify Stability

As much as quality stocks on their own can fortify an equity portfolio, we find that quality’s true power shines when combined with other equity factors, such as low volatility stocks.

When markets take a dive — more than 10% or more — it takes real fortitude for some investors to hold steady. This behavioral bias is called loss aversion, which can cause investors to make portfolio decisions during choppy markets that can be very costly.  For investors seeking a greater degree of defense without cutting equity exposure, we find that pairing quality with low volatility stocks — or stocks with the lowest price volatility — can aid portfolio stability and long-term performance.

Low volatility stocks over time have historically limited losses in down markets by about half and participated in 75% of the upside.[4] Exhibit 2 shows how a 50/50 quality/low volatility portfolio also outperformed the broad market, with lower volatility than the broad market and Exhibit 1’s quality-only portfolio.

Anchor Portfolios to Better Navigate Market Uncertainty

No investor can predict when volatility will strike or when sudden rallies will occur. However, we believe well-designed portfolio anchored in quality — and for more risk-averse investors quality combined with low volatility stocks — can prove a useful tool to navigate the spectrum of market conditions through the market cycle.

[1]Source: Northern Trust, Bloomberg. From 2009 to 2024, missing the largest five daily gains in the Russell 1000 Index reduced the cumulative return on a $100 initial investment to $611 from $890 for all days, a 31% decrease. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Indexes are the property of their respective owners, all rights reserved.

[2]See Foundations in Factors, Northern Trust, 2024

[3]Source: Northern Trust, FTSE-Russell. Data from December 31, 1983 to December 31, 2024. To create the portfolio of quality equity companies, we used the top quintile of stocks in the Northern Trust Quality Index based on our quality score. Upside market capture is, during months when the Russell 1000 Index return is positive, the average monthly return of quality equities divided by the average monthly return of the Russell 1000 Index. Downside capture is, during months when the Russell 1000 return is negative, the average monthly return of quality equities divided by the average monthly Russell 1000 return.

[4] Source: Northern Trust, FTSE-Russell, Barra. Time period from December 31, 1983 to December 31, 2024. To create the portfolio of low volatility stocks, we used the Barra multi-factor risk model for equities. Upside market capture is, during months when the Russell 1000 return is positive, the average monthly return of low volatility equities divided by the average monthly return of the Russell 1000 Index. Downside capture is, during months when the Russell 1000 return is negative, the average monthly return of low volatility equities divided by the average monthly Russell 1000 return.