In the fourth video in our seven-part asset allocation series, Kevin Barr, head of SEI’s Investment Management Unit, and Jim Smigiel, SEI's Chief Investment Officer, talk about about why low-volatility equities play a key role in our strategies.
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Kevin Barr - Hi, I'm Kevin Barr, Head of SEI's Investment Management Unit. Welcome to the fourth video in our Asset Allocation series. Today we'll be talking about why low volatility equities play a key role in our strategies. I'm again joined by our Chief Investment Officer, Jim Smigiel. Jim, thanks for joining me today. To start, can you describe the role of low volatility equities in a diversified portfolio?
Jim Smigiel - Sure. We at SEI we're pioneers in low volatility equity investing, having launched our first strategy in the space about 15-years ago. Our research found that lower volatility stocks typically deliver market-like returns over the long-term while experiencing considerably less volatility and lower declines than the market as a whole. This makes low volatility equities particularly attractive for investors who prefer to be at the lower end of the risk-return spectrum. These investors care about absolute risks, meaning they're more concerned about the risk of losing money as opposed to the risk of underperforming some market index. For example, if the goal is to avoid losses greater than a certain amount, say 10 or 20%, low volatility strategies may be especially compelling. That's not to say that low volatility strategies are limited to the most conservative portfolios, even the most aggressive investors may benefit from an allocation that's designed to dampen portfolio volatility.
Kevin Barr - Market-like returns over the long-term and less volatility sounds like an attractive combination. Why isn't everyone investing in these low volatility strategies?
Jim Smigiel - Well, there's a couple of major reasons for that. And the first one I've actually already alluded to. While low volatility equities generally exhibit less absolute risk than the equity markets as a whole, they can sometimes perform quite differently for extended periods of time. Sometimes outperforming by large margins and sometimes underperforming by large margins. That divergence is not something that everyone is comfortable with when it happens in their portfolios. I would make the case that if your asset allocation decisions are based on achieving a certain financial goal, be it for retirement or college tuition, a vacation home or some other spending objective, the risk of gain or loss relative to the market shouldn't really matter. If you need a 6% return to achieve your objective, and let's say your portfolio was up 20%, you should be happy that you are way ahead of expectations and are on your way to achieving your goal rather than unhappy that the market may be up more, say 25%. But not every investor thinks this way. And many professional money managers are incentivized to create a portfolio that looks a lot like the benchmark. Their compensation literally declines if they underperform the benchmark. Accordingly, they seek to manage risk relative to the benchmark, not the absolute risk of loss. And many investors are conditioned to judge the success of their portfolios against benchmark indices instead of benchmarking progress in relation to their own personal goals. So, even though the merits of a low volatility investment strategy have been understood for quite some time, a lot of investors judge their portfolios relative to the market and are uncomfortable with a portfolio that isn't exactly managed in that way. Another reason that low volatility investing is not universally adopted, is likely that investors often favor trades with lottery-like outcomes. You can think of this as similar to a cocktail party affect, if you will. Stocks that deliver consistent strong returns over the long-term are simply less exciting to talk about. Most people are more entertained when discussing high volatile companies that could deliver either giant gains or massive losses over relatively short periods of time. When an upstart electric car company is more exciting to own than a 130-year old highly successful profitable pharmaceutical company, we believe investors appear willing to pay a premium for the entertainment, overpaying for the car company and underpaying for the pharmaceutical firm compared to what maybe rational financial theory would indicate the companies are actually worth. This means that investors who are willing to potentially allocate to unexciting companies should be able to buy stocks at bargain prices and could be rewarded in the form of higher risk adjusted returns as the value of their boring investments slowly compound over time.
Kevin Barr - Speaking of unexciting assets, some people say low volatility equities are bond-like, delivering steady returns while being more influenced by events in the bond market than events in the stock market. With that in mind, are you worried about their exposure to rising interest rates?
Jim Smigiel - It is true that low volatility equities exhibit a moderate amount of interest rate sensitivity, particularly over certain periods of time. But that's not necessarily a bad thing for a couple of different reasons. Firstly, timing interest rate movements is just as hard as timing stock price movements. It's not as simple as just saying interest rates are low and therefore they have to rise, let alone announcing with any degree of confidence that they will rise at a faster pace than say the market anticipates. So, since we can't predict the future, interest rate exposure remains a valuable diversifier to equity risk. And second, as we've discussed in prior videos, it's important to remember that even many traditional balanced portfolios have far less interest rate risk than one might expect. In a 50-50 stock-bond portfolio, you can see that the stocks account for more than 95% of the risk. From that perspective, low volatility equities combination of smaller contributions to relative returns and modestly higher interest rates sensitivity isn't a big concern in our view. In fact, if anything it may bring the portfolio into better balance from a risk perspective. Finally, it is helpful to remember that the relationship between interest rates and equities varies throughout time. Recently, the equity markets have been dominated by technology-related growth names. Those stocks are meaningfully what we would call long duration in the sense that most of their earnings are projected well into the future. So in the event that interest rates rise faster than expected, it's far from clear that those technology-related growth stocks would outperform low volatility stocks. Applying higher rates to future earnings may well hurt long duration stocks just as much.
Kevin Barr - Jim, let's turn to recent activity. Low volatility strategies provided little, if any protection during the equity sell-off in early 2020. Does this shake your confidence in their ability to deliver on their stated goals in the future?
Jim Smigiel - That's a fair question for sure. Well, many equity market crises share similar features. It is important to realize that no two episodes are exactly the same. The sell-off in 2020 was especially unusual given the economic circumstances created by this once in a lifetime pandemic. Safety measures including government mandated lockdowns at the time made it unsafe, practical, or even illegal for consumers to purchase certain goods and services through traditional in-person channels. While most businesses were struggling, the few that had already mastered delivering products straight to consumers doorsteps or even living rooms, thinking about online shopping or on-demand movies and so forth, these companies outperformed in that environment. Traditionally, these high flying tech names are not low volatility stocks. The only reason they outperformed in 2020 was because of their unique advantage given the nature of a public health crisis. In a more typical equity sell-off, we wouldn't expect them to provide much of a cushion, if any, from losses. So putting aside the global pandemic, we more commonly see general economic weakness that causes consumers to spend less and businesses to invest less leading to contraction in corporate earnings that hit more discretionary areas of spending especially hard. This is intuitive because discretionary spending is by definition, non-essential. And therefore it is the easiest expense for both consumers and companies to cut when needed. The good news is that low volatility equities have performed remarkably well in just about every other market sell-off in recent memory. While we certainly can't know anything for certain about the next crisis, history does suggest that 2020 was the exception and not the new normal. And therefore, low volatility equity investments should continue to help mitigate losses in the vast majority of market draw downs going forward.
Kevin Barr - That's an important point and a good one to end on. The next time we get together, we'll provide our perspectives on inflation protection as part of a diversified portfolio. Thanks a lot, Jim.
Jim Smigiel - Thanks, Kevin.
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