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Markets have been facing waves of volatility this year. Kim Parlee speaks with Emin Baghramyan, Lead Portfolio Manager, Global Low-Volatility Equities at TD Asset Management, about why low-volatility stocks could be entering a ‘Goldilocks’ scenario and the potential opportunities for investors.
Transcript
Kim Parlee: I know that you’re saying right now that there’s a Goldilocks environment coming for low-volatility stocks. Before you tell me what you mean by the Goldilocks environment, let’s just back up and say what are low-volatility stocks?
Emin Baghramyan: Low-volatility stocks are basically the stocks that tend to have lower than average historical return volatility. They tend to be mostly low beta, and they tend to outperform in the environments where markets go down a lot.
Kim Parlee: So the idea is that you might get a similar return, but you’re not going to be as bumpy, the ride to get there, is that right?
Emin Baghramyan: Exactly.
Kim Parlee: Okay. So let’s talk about Goldilocks then, because, I think, probably every person listening, just their ears perked up because it has not felt like Goldilocks right now.
Emin Baghramyan: Indeed. So currently, we’re watching this incredible battle between inflation and central banks around the world. And when we say Goldilocks, we really mean is that no matter who wins in this battle, low-volatility stocks are poised to outperform. Let me explain. So on one hand, we have this seems like inflation has upper hand. It keep coming in hotter than expected. And if the inflation comes in like that, monetary policy will stay tighter for longer, and basically, it will delay, most importantly the Fed pivot. In that environment, stocks that tend to be highly levered, they tend to have volatile profitability and tend to be expensive, they are underperform.
Kim Parlee: Right.
Emin Baghramyan: But low-volatility stocks tend to have the opposite characteristics. They tend to be stable. They tend to have stable profit outlook, not very expensive, and not very leveraged. And that they will outperform in that scenario. However, if central banks are successful in their fight with inflation, then we’ll probably come at the expense of significant slowdown in economic growth and possibly or unfortunately a recession. And given their low beta qualities and defensive nature, low-vol stocks will outperform in that scenario as well. That’s what we mean when we say low while stocks are in Goldilocks.
Kim Parlee: Okay. The Goldilocks, as you define it too is — and I love this, you’ve got a fire and ice scenario, again, Game of Thrones. This is kind of what we’re looking at here. So take me through the fire scenario. You’ve got a chart here, we’ll bring it up, and maybe just explain to us what we’re looking at and why it matters.
Emin Baghramyan: Yeah, sure. So fire is where — remember that inflation is going to keep coming in hotter than expected, keeping rates higher. So what that means is usually bad news for tech stocks. And here, look at this chart. The orange line is basically showing the percentage of tech stocks. And tech stocks, when I say, includes IT sector and tech-related industries, such as interactive media and internet stocks. The percentage of tech stocks in the benchmark is as high as it has ever been. It’s still higher than the highs of the previous NASDAQ bubble and in comparison to the energy stock bubble of the early ’80s. And it’s still higher than the exposure to financial stocks that in the US that we had in 2000s during the housing bubble. So if tech stocks continue facing this headwind from higher interest rates, in that environment, the low-volatility funds that tend to have moderate exposure to technology will do well.
Kim Parlee: It’s interesting too because as you said that, I think something clicked for me when we were speaking before the show happened too, where you think even the big indexes, like the S&P 500, have so much more of tech than they ever used to have in it. So even if you’re a passive investor into these indexes, you’re going to be hit harder with the volatility than you might be with the low-vol funds. Correct?
Emin Baghramyan: Exactly. Yep. Exactly.
Kim Parlee: Okay, let’s go to the ice scenario. Let’s bring this one up, and this is the recession scenario.
Emin Baghramyan: Yeah. Ice implies basically a significant contraction in economic growth, deceleration, and possibly recession, because it’s very hard to expect inflation that we had 9.9% back in the summer in the US at the peak, bring back below 2% target without having a significant slowdown in growth. So we went back and looked at here at the T denotes the start of the recession, and T-6 the six months before and six months after. If we look at the recession, the performance of the broad market around the recession, so we went back to 1960s and we look at every US recession, and measured the performance of the broad market and low-volatility stocks. And on average, you can see that while low-volatility stocks keep their value, they are hovering around 100. You can see the line, and it’s basically down 0.7% historically, on average. While, in the meantime, the broad market declines by about 6.7%. So in that environment too, the low-vol strategies are very good way to navigate these choppy waters of possible recession.
Kim Parlee: So, you’ve made the case, and I know, again, being someone who comes from Quant background. Obviously, you’ve seen what happens in, like you mentioned, high inflation or recession, both sides. One concern I know some people have mentioned too is about some of these low-vol stocks are often used as a proxy for fixed income. So wouldn’t higher rates, which we’re headed towards, be bad for these kinds of stocks then?
Emin Baghramyan: Well, indeed. I would say to start with there is no conclusive evidence of that. So if we look at over the past 40 years, one could argue that, yeah, low-vol stocks have indeed outperformed by about 1.5% each per year, their benchmark, their peers, the broad market average. And over the past 40 years, we indeed had interest rates declining steadily. But let’s look at another period, the one before that, for about 28 years, from 1953 till the early 1980s, interest rates have been steadily rising, and, surprise, low-volatility stocks outperformed again by about 1% each year. So it’s very hard to argue that high interest rates will be bad in the long run for low-volatility investing strategies.
Kim Parlee: What about inflation?
Emin Baghramyan: We look at that as well. So over the past six years, compared to the similar episode where you had a very big run-up in inflation about 8% in a short period of time, we had two episodes like that. One was early ’70s during the Yom Kippur War. And the second one was late ’70s during the Iranian Revolution. And interestingly, in the first episode, low-vol stocks outperformed. That’s because going into that crisis, low-vol was overweight energy, because energy back in the day was not considered risky. But during ’70s, the riskiness of the sector has increased. And going into second crisis, low-vol was underweight energy hence underperformed the benchmark. So the bottom line is whether you have high inflation or low inflation, whether you have high interest rates or low interest rates, it’s the sectoral composition and direction of the market that matters more for low volatility’s relative performance.
Kim Parlee: For the people who want to start figuring out, what’s a low-vol stock and actually getting in there, I should just mention, TD Asset Management has ETFs and funds where you do the work for them. So they can figure it out. But maybe just tell us, in terms of sectors, can you give us some examples of what qualifies?
Emin Baghramyan: Yeah, sure. So, well, it depends. Let’s say if we want to invest in US and we go take the health care sector, we can find a lot of low-volatility stocks in that sector to include in our portfolios. However, we can’t really do that in Canada because Canadian health care sector is overrepresented by cannabis producers who tend to have very high volatility —
Kim Parlee: And a small pool too.
Emin Baghramyan: And a small pool, exactly. But regardless of the universe, whether we look at Canada, whether we look at US or global, I would say consumer staples, utilities, and telecoms are the main sectors that we find a lot of stocks for our global portfolios.
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