Following a nine-year bull market in global equities which has seen the MSCI World Index more than double Australian dollar terms, volatility has once again returned to global markets in 2018.

In recent years, markets have been inflated by a number of tailwinds — ultra-low interest rates, improving economic fundamentals, corporate profit appreciation and strong passive flows from institutional investors and the Exchange Traded Fund (ETF) market.

However, this year a number of risks have emerged that are waving red flags for this unprecedented period of growth.

Geopolitical threats from a nuclear North Korea, contentious Brexit negotiations, and a brewing US–China trade war have disrupted global markets, leaving investor returns barely positive in the final months of trading for the calendar year. If that wasn’t enough, the US political machinations continue to provide fodder for skittish investors.

In addition, the era of “cheap money” is firmly behind us as some governments around the world have begun the process of quantitative tightening, increasing interest rates and implementing more stringent rules around bank lending.

These factors have collectively contributed to a weakening of the bull market and invoking a higher degree of caution in investors.

Where to from here?

For investors concerned about market volatility and future returns, it can be tempting to pull out of the market altogether.

Successfully timing the market — selling near its peak and buying again near its trough — is incredibly difficult to do, even for professionals. Succumbing to the temptation can cost dearly, both in lost returns and taxes while sitting it out.

Another approach for investors to consider is rebalancing their portfolio’s exposure to defensive “quality” assets. In a volatile environment, fundamentals rather than momentum will drive performance and growth and we believe in 2019 that a bottom-up stock selection process will provide investors with superior returns than passive index-style investing.

Choosing the right stocks within the right sectors, however, is easier said than done. In our view, “growth” stocks are currently looking very expensive after a period of strong performance and “value” stocks, while cheap, are not looking undervalued.

Therefore, we are focusing our attention to quality stocks which are cheaper than growth stocks, have less fundamental risk than value stocks and offer good protection in down markets. Notably, from a performance perspective, quality stocks have consistently outperformed the broader market in a range of volatile market conditions, as shown below.

If we look at the MSCI Quality Index over the last eight down markets, quality stocks have added value in every year when the MSCI World Index has been negative, averaging 7 per cent.

These stocks can also perform well in up markets, outperforming the broader market in nine out of 19 years. This highlights the ability of “quality” to perform well in different market conditions — something which investors going into 2019 should pay heed to.

Uncovering quality opportunities

Increasing volatility is a good thing for active managers. It fosters an environment where more stocks are mispriced which opens attractive buying and selling opportunities. We witnessed an aggressive sell-off in October which saw the big growth stocks and tech leaders hit the worst.

For investors looking to identify “quality” companies that will outperform the market over the long term, we recommend look for specific attributes and combinations of attributes including: the capability and past successes of management, franchise strength, consistent profitability, financial strength and favourable business and economic drivers like an ageing population driving the pharmaceuticals and aged-care industries.

In addition to rebalancing our portfolios away from cyclicals like financials and energy, one segment of the market where we are increasingly seeing value is in Global SMID or global small and mid-cap stocks. The MSCI World SMID Index is now trading at its biggest discount to the broader market in 10 years.

Exposure to these companies can provide diversification to an investor’s portfolio and can complement existing large and mega cap exposures. Global SMID companies are also less exposed to global trade risks and unpredictability.

Take action

Global equity risks are building and there is now a greater need for investors to focus on companies that can be expected to be resilient in the face of greater market volatility.

Since index weights do not account for market risks and future earnings potential, passive investors following common benchmarks will be exposed to potentially underperforming stocks.

We believe active management, with a focus on quality assets, will be a better proposition for investors looking to protect their portfolio from economic and geopolitical risks.

Ned Bell is chief investment officer at Bell Asset Management