Show Transcript
Recent stock market gyrations have rattled global markets amid concerns about inflation, the economy, and earnings. Emin Baghramyan, Vice President, Director and Lead of Quantitative Portfolio Management at TD Asset Management, speaks with MoneyTalk’s Greg Bonnell about how a low volatility investing approach may help to mitigate some market risks.
Print Transcript
[AUDIO LOGO]
* Investors were dealt a brief but dramatic dose of volatility this summer with several major events on the horizon. Could the environment be right to consider a low-volatility investing approach? Joining us now to discuss is Emin Baghramyan, VP Director and lead of quantitative portfolio management at TD Asset Management. Emin, always great to be with you.
* Thanks for having me, Greg.
* All right, so we did get that brief dose of volatility, had people thinking along those lines. Why is this a good time to consider low volatility, despite what we've seen, a pretty strong rally in the markets?
* Before we start considering the reasons why it's a good time to consider low-volatility investing, let me give you a very brief reminder of what low-volatility investing is. So low volatility is basically a strategy where we seek out these low-risk companies that tend to be well established with stable earnings and mostly represented in defensive sectors, such as consumer staples, utilities, health care. And the goal of this strategy is to generate highest possible risk-adjusted returns.
* So the main characteristic of the portfolio that consists of these type of stocks is to generate the most added value bread and butter, to say, is the environment where market volatility is high and economic growth is scarce. And that brings me to the first reason why investors should consider investing in low volatility strategies.
* If we look at the state of the global economy from China, that is currently facing its housing slump, to other emerging markets that are main trading partner is China and they're facing that weak Chinese demand to Europe, to UK, to even North America, where we had United States growth doing much better than every other larger economy, where we're also seeing these first signs of economic weakness going into end of 2024, towards 2025.
* Where there's debate, whether it's soft landing or hard landing and et cetera, what we can be sure of, that economic growth is weakening around the world. And that's usually-- history tells us in that kind of environment, major equity benchmarks do not do well. The recessions, weak growth are accompanied by major correction in benchmarks and even possible bear markets. So that's the first reason why investors should consider investing in low-volatility strategies.
* The second reason is that major equity benchmarks, at the moment, are extremely concentrated and into very few selected themes, which is mostly AI related. Here, I brought a slide with me to demonstrate. This is basically showing-- let's first look at the line, the purple line there. It's showing that only five stocks in the S&P 500 or MSCI All Country World Index contribute more than a third of the benchmark risk.
* And they tend to be volatile, large mega-cap stocks in IT sector. So if we look at the first shaded area, that's the IT sector. And we look at the other lines that are communication services sector and the consumer discretionary sector. And we know this sector is dominated by Amazon and Tesla and Netflix. And they're more IT type of stocks.
* And if we look at that, 70% of the benchmark risk is coming from these selected stocks or in a very few concentrated sectors. And history also tells us that this concentration cannot last for long. And eventually, extreme levels of concentration in benchmarks, which we saw in the '70s with energy stocks, then we saw in the late '90s in the NASDAQ bubble times, then in mid-2000s with financial stocks, eventually gets deconcentrated.
* We don't have a crystal ball to say when exactly that will happen. But that concentration of the benchmark tells us that investing in equities and trying to realize your equity risk premium is not very efficient right now to doing it. We have this cap-weighted benchmark. So low volatility is a stronger alternative to do that and to weather these kind of storms.
* Let's talk about that kind of efficiency-- yeah, I understand that you're talking about low volatility and low-volatility investing. You say it is efficient, performs well over the longer term.
* Yes, exactly. So another reason is the volatility strategy is about longer term. So it doesn't matter when you really get into it. I mean, you can have a better starting point or a worse starting point. And maybe this concentration story has a lot more legs to go, a few more months or quarters. But low volatility is about long-term investing.
* So I brought another slide to show you that over the past 50 years, if you were investing only low-volatility quintile, the segment of the stocks, the strategy over the full market cycle, over the few long-term periods, you can see that actually outperforms the cap-weighted benchmark in this case.
* It's shown for the United States. And it's also-- we compare it to a US Treasury index. So the two major asset classes that have done really well over the past 50 years. And in the US, where we had the strongest equity and fixed-income returns, we can see that low-volatility strategy does really well over the long period of time.
* When we start thinking about the strategy, what kind of stocks, what kind of sectors are we thinking about?
* So it depends that on the investment universe, of course, and what the strategy is seeking. So given its investment universe, whether you're investing in low-volatility Canadian stocks or whether you're investing in low-volatility US stocks or global stocks, so that has a little bit different characteristics.
* For example, some of the financial companies in the US, they tend to be on more riskier sides. Even what we saw in regional banks and even larger banks from 2000, they tend to be more volatile. So they're not that represented in US volatility strategies.
* However, in Canada, where we have a lot more representation, a lot more well-established and safer financials, insurance companies, and tech-- sorry, banks, we have more of a representation of these type of companies in Canadian benchmark. However, the main common point is that these are the companies that you-- easier to find in consumer staples, grocers and retailers and soft drink producers and food producers.
* They are also utility companies that tend to be very-- with stable earnings. And they tend to be very stable and providing this defensive quality in health-care companies. You find it in all sectors. It doesn't mean that you will never find a defensive tech company or defensive energy company. But the biggest sectors tend to be telecoms, utilities, consumer staples, and health care.
* If an investor is doing their homework on low-volatility investing, what risks do they need to be aware of?
* You know, one of the main risks that investors should think about when they start investing in low-volatility strategy, that is not really a short-term strategy. There will be periods where you will have-- think of, let's say, right in the aftermath of the COVID pandemic relief that we had, or right at the beginning after the 2008-2009 financial crisis, or when you have that kind of environment where interest rates are slashed to 0, where you have a very strong market rally that recovers from extreme oversold levels.
* Obviously, the defensive strategies will lag their benchmarks. So if investors are thinking into relative performance terms, they might face a situation where they look at their equity holdings in low volatility, compare that to benchmark, and say they have been lagging. But they have to remember that the strategy's goal is this asymmetry. So when you cut down your downside, you obviously need to pay for it somehow.
* And the payment is on a very strong performance times. But the mathematics of the compounding, where you decline less than the benchmark and you kind of try to keep up as much as possible when the market rallies, over a very long term, it allows you to be very efficient and to generate the highest possible risk-adjusted return.
[AUDIO LOGO]
[MUSIC PLAYING]
* Investors were dealt a brief but dramatic dose of volatility this summer with several major events on the horizon. Could the environment be right to consider a low-volatility investing approach? Joining us now to discuss is Emin Baghramyan, VP Director and lead of quantitative portfolio management at TD Asset Management. Emin, always great to be with you.
* Thanks for having me, Greg.
* All right, so we did get that brief dose of volatility, had people thinking along those lines. Why is this a good time to consider low volatility, despite what we've seen, a pretty strong rally in the markets?
* Before we start considering the reasons why it's a good time to consider low-volatility investing, let me give you a very brief reminder of what low-volatility investing is. So low volatility is basically a strategy where we seek out these low-risk companies that tend to be well established with stable earnings and mostly represented in defensive sectors, such as consumer staples, utilities, health care. And the goal of this strategy is to generate highest possible risk-adjusted returns.
* So the main characteristic of the portfolio that consists of these type of stocks is to generate the most added value bread and butter, to say, is the environment where market volatility is high and economic growth is scarce. And that brings me to the first reason why investors should consider investing in low volatility strategies.
* If we look at the state of the global economy from China, that is currently facing its housing slump, to other emerging markets that are main trading partner is China and they're facing that weak Chinese demand to Europe, to UK, to even North America, where we had United States growth doing much better than every other larger economy, where we're also seeing these first signs of economic weakness going into end of 2024, towards 2025.
* Where there's debate, whether it's soft landing or hard landing and et cetera, what we can be sure of, that economic growth is weakening around the world. And that's usually-- history tells us in that kind of environment, major equity benchmarks do not do well. The recessions, weak growth are accompanied by major correction in benchmarks and even possible bear markets. So that's the first reason why investors should consider investing in low-volatility strategies.
* The second reason is that major equity benchmarks, at the moment, are extremely concentrated and into very few selected themes, which is mostly AI related. Here, I brought a slide with me to demonstrate. This is basically showing-- let's first look at the line, the purple line there. It's showing that only five stocks in the S&P 500 or MSCI All Country World Index contribute more than a third of the benchmark risk.
* And they tend to be volatile, large mega-cap stocks in IT sector. So if we look at the first shaded area, that's the IT sector. And we look at the other lines that are communication services sector and the consumer discretionary sector. And we know this sector is dominated by Amazon and Tesla and Netflix. And they're more IT type of stocks.
* And if we look at that, 70% of the benchmark risk is coming from these selected stocks or in a very few concentrated sectors. And history also tells us that this concentration cannot last for long. And eventually, extreme levels of concentration in benchmarks, which we saw in the '70s with energy stocks, then we saw in the late '90s in the NASDAQ bubble times, then in mid-2000s with financial stocks, eventually gets deconcentrated.
* We don't have a crystal ball to say when exactly that will happen. But that concentration of the benchmark tells us that investing in equities and trying to realize your equity risk premium is not very efficient right now to doing it. We have this cap-weighted benchmark. So low volatility is a stronger alternative to do that and to weather these kind of storms.
* Let's talk about that kind of efficiency-- yeah, I understand that you're talking about low volatility and low-volatility investing. You say it is efficient, performs well over the longer term.
* Yes, exactly. So another reason is the volatility strategy is about longer term. So it doesn't matter when you really get into it. I mean, you can have a better starting point or a worse starting point. And maybe this concentration story has a lot more legs to go, a few more months or quarters. But low volatility is about long-term investing.
* So I brought another slide to show you that over the past 50 years, if you were investing only low-volatility quintile, the segment of the stocks, the strategy over the full market cycle, over the few long-term periods, you can see that actually outperforms the cap-weighted benchmark in this case.
* It's shown for the United States. And it's also-- we compare it to a US Treasury index. So the two major asset classes that have done really well over the past 50 years. And in the US, where we had the strongest equity and fixed-income returns, we can see that low-volatility strategy does really well over the long period of time.
* When we start thinking about the strategy, what kind of stocks, what kind of sectors are we thinking about?
* So it depends that on the investment universe, of course, and what the strategy is seeking. So given its investment universe, whether you're investing in low-volatility Canadian stocks or whether you're investing in low-volatility US stocks or global stocks, so that has a little bit different characteristics.
* For example, some of the financial companies in the US, they tend to be on more riskier sides. Even what we saw in regional banks and even larger banks from 2000, they tend to be more volatile. So they're not that represented in US volatility strategies.
* However, in Canada, where we have a lot more representation, a lot more well-established and safer financials, insurance companies, and tech-- sorry, banks, we have more of a representation of these type of companies in Canadian benchmark. However, the main common point is that these are the companies that you-- easier to find in consumer staples, grocers and retailers and soft drink producers and food producers.
* They are also utility companies that tend to be very-- with stable earnings. And they tend to be very stable and providing this defensive quality in health-care companies. You find it in all sectors. It doesn't mean that you will never find a defensive tech company or defensive energy company. But the biggest sectors tend to be telecoms, utilities, consumer staples, and health care.
* If an investor is doing their homework on low-volatility investing, what risks do they need to be aware of?
* You know, one of the main risks that investors should think about when they start investing in low-volatility strategy, that is not really a short-term strategy. There will be periods where you will have-- think of, let's say, right in the aftermath of the COVID pandemic relief that we had, or right at the beginning after the 2008-2009 financial crisis, or when you have that kind of environment where interest rates are slashed to 0, where you have a very strong market rally that recovers from extreme oversold levels.
* Obviously, the defensive strategies will lag their benchmarks. So if investors are thinking into relative performance terms, they might face a situation where they look at their equity holdings in low volatility, compare that to benchmark, and say they have been lagging. But they have to remember that the strategy's goal is this asymmetry. So when you cut down your downside, you obviously need to pay for it somehow.
* And the payment is on a very strong performance times. But the mathematics of the compounding, where you decline less than the benchmark and you kind of try to keep up as much as possible when the market rallies, over a very long term, it allows you to be very efficient and to generate the highest possible risk-adjusted return.
[AUDIO LOGO]
[MUSIC PLAYING]
