Richard Drury
Recent stock market swings have rattled global markets amid concerns about inflation, the economy and earnings. Emin Baghramyan, Vice President, Director and Leader of Quantitative Portfolio Management at TD Asset Management, speaks to MoneyTalk's Greg Bonnell about how a low-volatility investment approach It can help mitigate some market risks.
Transcription
Greg Bonnell- This summer, investors were treated to a brief but dramatic dose of volatility, with several major events on the horizon. Could this be the right environment to consider a low-volatility investment approach? Emin Baghramyan, Vice President and Head of Quantitative Portfolio Management at TD Asset Management, joins us to discuss this topic. Emin, it’s always a pleasure to be with you.
Emin Baghramyan – Thanks for having me, Greg.
Greg Bonnell- Okay, we had that brief bout of volatility, which got people thinking along those lines. Why? Is this a good time to consider low volatility, despite what we have seen, a fairly strong rally in the markets?
Emin Baghramyan – Before we start looking at the reasons why it is a good time to consider low volatility investing, let me briefly remind you what low volatility investing is. Basically, low volatility investing is a strategy where we look for low-risk companies that tend to be well-established, with stable earnings, and represented primarily in defensive sectors, such as consumer staples, utilities, and healthcare. And the goal of this strategy is to generate the highest risk-adjusted returns possible.
So the main feature of the portfolio that is made up of this type of stocks is to generate the highest possible added value, that is, it is the environment in which market volatility is high and economic growth is low. And that brings me to the first reason why investors should consider investing in low volatility strategies.
If you look at the state of the global economy from China, which is currently facing its housing crisis, to other emerging markets whose main trading partner is China, and they are facing that weak Chinese demand, to Europe, the UK and even North America, where US growth was much better than any other major economy, where we are also seeing these first signs of economic weakness in late 2024, into 2025.
In cases where there is a debate about whether it is a soft landing or a hard landing, etc., what we can be sure of is that economic growth is weakening all over the world. And that is often the case – history tells us that in that kind of environment, the major equity benchmarks do not perform well. Recessions and weak growth are accompanied by major corrections in the benchmarks and even possible bear markets. So that is the first reason why investors should consider investing in low volatility strategies.
The second reason is that the major equity benchmarks, right now, are extremely concentrated and in very few select themes, which are mostly related to AI. I brought a slide here to demonstrate this. Basically, this shows… let’s look first at the line, the purple line that’s there. It shows that just five stocks in the S&P 500 or the MSCI All Country World Index contribute more than one-third of the benchmark’s risk.
And they tend to be volatile, large mega-cap stocks in the IT sector. So if we look at the first shaded area, that's the IT sector. And we look at the other lines which are the communication services sector and the consumer discretionary sector. And we know that this sector is dominated by Amazon, Tesla and Netflix. And they're more IT-type stocks.
And if you look at that, 70% of the benchmark risk comes from these select stocks or a few concentrated sectors. And history also tells us that this concentration cannot last for long. And over time, the extreme levels of concentration in benchmarks, which we saw in the 1970s with energy stocks, then in the late 1990s at the time of the Nasdaq bubble, then in the mid-2000s with financial stocks, eventually deconcentrate.
We don't have a crystal ball to say exactly when that will happen, but that concentration of the benchmark tells us that investing in stocks and trying to get the equity risk premium is not very efficient right now. We have this capitalization-weighted benchmark, so low volatility is a more robust alternative to do that and weather these kinds of storms.
Greg Bonnell- Let's talk about that kind of efficiency. Yes, I understand that you are talking about low volatility and low volatility investment. You say that it is efficient, that it has a good long-term performance.
Emin Baghramyan – Yes, exactly. Another reason is that the volatility strategy is focused on the long term, so it doesn't matter when you start investing. That is, you can have a better starting point or a worse one. And maybe this concentration story has a lot more to go, a few more months or quarters. But low volatility is focused on long-term investing.
So, I brought up another slide to show you that over the last 50 years, if you were investing in just the low volatility quintile, the equity segment, the strategy over the full market cycle, over the few long-term periods, you can see that it actually outperforms the cap-weighted benchmark in this case.
It's shown for the United States. And we also compare it to a US Treasury index. So the two major asset classes that have performed really well over the last 50 years. And in the United States, where we had the strongest returns in equities and fixed income, we can see that the low volatility strategy works really well over a long period of time.
Greg Bonnell- When we start thinking about strategy, what kind of actions, what kind of sectors are we thinking about?
Emin Baghramyan – Of course, it depends on the investment universe and what the strategy is looking for. So, given the investment universe, whether you invest in low-volatility Canadian stocks or low-volatility U.S. or global stocks, it has slightly different characteristics.
For example, some of the US financial firms tend to be riskier. Even what we saw in regional banks and even in larger banks starting in 2000 is that they tend to be more volatile, so they are not as represented in US volatility strategies.
However, in Canada, where we have a much larger representation, more established and secure financial institutions, insurance companies, technology companies – sorry, banks – we have a larger representation of these types of companies in the Canadian benchmark index. However, the main commonality is that these are the companies that are most easily found in the consumer staples, grocery and retail, soft drink producers and food producers sectors.
They are also utility companies that tend to have very stable earnings and tend to be very stable and provide this defensive quality in healthcare companies. You find it in every sector. It doesn't mean you'll never find a defensive technology company or a defensive energy company. But the biggest sectors tend to be telecom, utilities, consumer staples, and healthcare.
Greg Bonnell- If an investor is doing their homework on low volatility investments, what risks should they consider?
Emin Baghramyan – You know, one of the key risks that investors need to be aware of when they start investing in a low volatility strategy is that it's not really a short-term strategy. There will be periods where you'll have to think about, for example, right after 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 go down to zero, where you have a very strong market rally that recovers from extreme levels of overselling.
Obviously, defensive strategies will not perform as expected in relation to their benchmarks. So if investors think in terms of relative performance, they might find themselves in a situation where they look at their stock holdings under low volatility conditions, compare them to the benchmark, and say that they have not performed as expected. But they should remember that the goal of the strategy is this asymmetry. So when you reduce the downside risk, you obviously have to pay for it in some way.
And the payout is based on very good performance times. But the mathematics of compounding, where you lose less than the benchmark and try to keep up as much as possible when the market goes up, over the very long term, allows it to be very efficient and generate the highest risk-adjusted return possible.