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Markets are facing waves of volatility amid high inflation, rising rates and economic uncertainty. Greg Bonnell speaks with Emin Baghramyan, Lead Portfolio Manager, Global Low Volatility Equities at TD Asset Management, about how low volatility stocks may provide stability for portfolios.
Transcript
Greg Bonnell: Some of the big swings we’ve seen in the markets this year might be tough for some investors to handle. Well, if you’re looking for a little more stability, you might consider investing in low-volatility stocks. Joining us now for more on this space is Emin Baghramyan, Lead Portfolio Manager for Global Low Volatility Equities at TD Asset Management. Great to have you on the show.
Emin Baghramyan: Thanks for having me.
Greg Bonnell: So this might be piquing some people’s interest– low-volatility stocks. When we’re talking with the low-volatility space, what exactly are we talking about?
Emin Baghramyan: So let me explain first what’s low-volatility stock. These are the stocks that tend to have relatively low price volatility and relatively stable annual returns. So we can measure this low volatility, low risk of these companies in two ways. We can do it in standalone basis by measuring their historical standard deviation, or we can measure its correlation, also, with broad market. And we know if the broad markets’ beta is one, so the low-volatility stocks tend to have beta lower than one. So those are low-volatility stocks. Low-volatility investing is basically– is a investment style that is designed to invest in stocks with this type of characteristics and avoid companies that tend to be– with the opposite characteristics, meaning higher volatility. So that is based on the whole idea of– generating returns via low-volatility investing is turning the historically widely accepted market notion that you take more risk and you’re rewarded with higher returns. So we brought a chart here–
Greg Bonnell: Yeah. Myths versus reality– let’s take a look at this one.
Emin Baghramyan: So, indeed, if we look– it is very logical to assume if you’re taking more risk, you should get more returns. And historical data has shown some evidence of that– that kind of relationship exists between asset classes. If you go from cash to go to T-bills, from T-bills you go to longer-term government bonds, and then you go corporate bonds, and then you go to equities, that relationship exists. You take on more risk, and you are expected to be compensated for it. However, the relationship becomes a lot trickier when we go into within equity space by itself. So, after a certain point of time, investors tend to misprice the very risky parts of the market and then that is why that mispricing results in the fact that you are not being adequately compensated by investing in the most risky parts of the market. So what the low-volatility strategy means is that– to continuously avoid these risky parts and basically be able to generate market-like returns but with less risk, basically improving your efficiency in equity investing.
Greg Bonnell: That’s a great foundation. But the reason why we’ve seen all this volatility this year is because of the big macro concern, which is inflation, and what the central banks have been trying to do about it– by giving us jumbo-sized rate hikes. So you have pretty sticky inflation– trying to work it down. You’ve got central banks raising the cost of borrowing, setting off all this volatility. Do low-volatility strategies still work in that kind of environment?
Emin Baghramyan: We actually argued that low-volatility investing right now is facing this Goldilocks environment. We are– you are right– facing this incredible battle between central banks and inflation. And inflation has, so far, had kind of upper hand, forcing central banks to catch up with jumbo-sized rate hikes. But we are saying that, regardless of who wins in this battle between central banks and inflation, low vol would do well. And if inflation comes in stronger than expected– continues to do so– and that will keep interest rates higher for longer, that will put pressure on a lot of tech stocks and a lot of growth stocks that tend to be very volatile. They tend to be expensive. Their earnings tend to be less profitable, especially a lot of components of them. And the valuations of these companies will continue to be suppressed, even if interest rates go sideways from now on. This is shown in this chart, where we’re showing the valuation backdrop of IT stocks compared to interest rates.
And if we look on the– we have another slide. And if we look at the amount of tech stocks that is included in these still, in the benchmark, if you– we have a slide for that following. That is showing that the percentage of tech stocks in the benchmark is still significantly higher than it has been, even at the peak of the NASDAQ bubble. It is higher than what we have seen during early ’80s, when the energy stock bubble, and it is higher than financial stocks were during the housing bubble of 2008. So if rates keep staying high for longer, that will keep pressure on this growth in tech stocks, especially, and low-volatility strategies that tend to have very moderate exposure to these type of companies will do well.
And on the other hand, if–
Greg Bonnell: Goldilocks would mean two scenarios, right?
Emin Baghramyan: Yeah.
Greg Bonnell: That’s the first scenario. What’s the other side of the Goldilocks scenario?
Emin Baghramyan: Exactly. The other scenario is what if inflation comes down sharply. We have seen inflation that almost reached 10% in US. It was 9.1% in the summer. It’s coming down. The question is, how fast and how low will it get? And to expect it to go down to 2% in this very quickly manner, that means the– unfortunately, the growth will be decelerate sharply. That would mean higher unemployment rate. That would mean slower wage growth. That would mean, also, a weakness in corporate earnings. And given its defensive qualities, low vol should do well, also, in that scenario. So that is why we say we are in a Goldilocks scenario.
Greg Bonnell: When I think about how the markets have behaved this year with all of these challenges in front of them and the inflation and the central bank action, obviously, investors seek return over the long term. In the short term, there has been discussions this year just around, really, preservation of capital, given some of the selloffs we saw in the market. A low-volatility strategy– how does that work with those kind of concerns? They want to preserve some capital.
Emin Baghramyan: Yes, exactly. So it’s a very good question. If we look, there’s the whole philosophy behind low-volatility strategy working over the long term by preserving capital. We can visualize it by looking at this chart here. If we have an investment that has gone down 50% in a period– because we all– we can face a situation where an investment goes wrong and we’re down 50%– in order to recover that, we need 100% return of that. You can see the green bar, almost 100% of that, to recover the money lost. However, if we reduce that downside so we don’t experience a sharp drawdown of our initial capital, the recovery time and the recovery amount is significantly less. So, if we continue with that path when we don’t have big, big drawdowns, the power of compounding will allow low volatility to generate significant returns through time by avoiding this type of big, big drawdowns in the markets.
Greg Bonnell: An investor perhaps intrigued by what you’re saying right now, where do they begin their homework? If they say, OK, I want to start exploring a low-volatility strategy a little deeper, what should they be looking at?
Emin Baghramyan: So low-volatility strategies, they tend to invest in less economically sensitive sectors and– well, there are low-volatility stocks in every sector. We can maybe talk about that later. But generally, it is a lot easier to find low-volatility stocks in consumer staples, in utilities or telecoms rather than you find them in more economically sensitive industries such as materials, energy, or industrials.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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