Chris Jenks – Chris Jenks, I’m a director and client portfolio manager with the disciplined equity team at BMO Global Asset Management.
Ben Jones – When you’re at home, and your young child says, well Dad, what do you do for a living, how do you describe your role?
Chris Jenks – Oh, that’s a great question. I describe it as my job is to help inform people on what to do with their money. I think that’s the biggest benefit of my job, is just sitting there with the investment team, understanding what’s going in the markets, be able to synthesize that, educate people externally.
Ben Jones – I love it. Now, where are we today?
Chris Jenks – We are in beautiful Chicago, at the BMO Global Asset Management US headquarters.
Emily Larsen – Chris has been a guest on our podcast before when he appeared alongside David Corris on episode 47, “Rise of the Quants.”
Ben Jones – Due to the surge in investment dollars and the low volatility strategies, I was really excited to sit down with Chris and get some clarity on this topic. Now, you might know what low volatility is, but are unclear what low volatility investing really means. Chris is going to help us understand how to separate the truth from the hype when it comes to low vol labeling. First, I asked him to level-set the basic definition of what low volatility investing is.
Chris Jenks – Low volatility investing is investing utilizing a long-only fully invested equity portfolio, that has one objective, and that objective is to reduce volatility. This is really leveraging the insights and the academic research that supports the findings of the low volatility anomaly.
Emily Larsen – You heard Chris at the top of the show talk about the low volatility anomaly, but it’s basically the idea that over longer periods of time, lower risk stocks provide a greater reward than higher risk stocks, and this is the opposite of what investors typically believe, which is that with greater risk comes greater reward.
Ben Jones – This low volatility anomaly, has it always existed or is this a new phenomenon for our generation.
Chris Jenks – No, it’s always existed. We have research that goes back to somewhere around 1976, you could use data sets using the CRSP database or Kenneth French data, it all shows the same thing. The low volatility has existed for quite some time here.
Ben Jones – And so, if it’s existed for a long time, why is it an anomaly?
Chris Jenks – It’s an anomaly because it’s counterintuitive to everything that we’re taught to believe. It’s an anomaly because we are trained to associate this relationship between risk and return as positive, and it’s in fact negative, that anomalous.
Ben Jones – From your perspective, where did the capital asset pricing model go wrong? How did this — is this a new thing, or how did this not work.
Chris Jenks – Yeah. So capital asset pricing model, or CAPM, essentially takes that framework and translates it to investment perspective, and states that the expected return of an asset is a function of its systematic risk. And there’s a couple of flaws that are well documented in terms of the inputs of CAPM. First and foremost, using the risk-free rate to borrow, right. Investors typically can’t borrow the risk-free rate. Stationary —
Ben Jones – Maybe today.
Chris Jenks – Maybe today. True. The stationary nature of beta, right. Risk is changing, and also using beta is the only input in the equation. Right, beta just being a level of systematic risk for under risk, viable risk, and not taking into account other dimensions. But at the end of the day, the biggest flaw with CAPM is it assumes that markets are efficient, and markets are inefficient because irrational decision making behavioral biases that influence stock returns, and that’s a big driver for low volatility anomaly.
Ben Jones – And so, when you say that there’s some behavioral biases, maybe you could just help me, what does that mean? What are those behavioral biases that drive this?
Chris Jenks – Sure, there are a couple well documented. One would be the lottery effect. Right, so there is approximately a 1 in 300M chance that you and I are going to win the lottery. And despite the near certain outcome of just accepting a loss by purchasing a lottery ticket, right, that lottery ticket has a negative value on it, about half Americans play the lottery system. Right, this hyper return/reward seeking behavior that drives the mis-pricing of risk. The glamour effect, another well documented behavioral bias, which is partly — drives the low volatility anomaly. You have high flying growth companies, very sexy stories, investors have a tendency to fall in love with those companies and they pay big prices, expecting big returns. And very infrequently do these companies deliver, and this is, again, another big driver for low volatility anomaly.
Ben Jones – And so maybe give me an example of the glamour effect.
Chris Jenks – Real time, right now, a Tesla. Let’s look at a company like Tesla, doubling year-to-date, already, and this may have changed here in the last couple of days, as the markets have pulled back. But, they’re a great example of it. If you were to look at their market cap per vehicle delivered, it’s somewhere in the ballpark, I think, of $380,000. Their combined market cap is greater today now than Ford, GM and Honda, and they deliver a fraction of the vehicles. And I think that’s just a great example of investors falling in love with the company’s potential, whether or not Tesla could truly displace the Fords, GMs and Hondas of the world. That’s the $1M question.
Ben Jones – Are the markets actually more volatile today, or is it a perceived amount of volatility?
Chris Jenks – It’s more perception. Sort of look at where volatility is, and I don’t want to say today, for example, because we are in the midst of a pretty big sell off here, as investors grapple with the ramification of coronavirus. But, if we’re to look at the last 12 months — VIX around its long-term average. It just feels like volatility is higher because we’re coming from a pretty low base. 2017, in particular, that was a year that was notated by extraordinarily low volatility. The VIX struggled to get to double digits there for quite some time, and coming off such a low base, it certainly feels like markets are increasingly volatile today. But, there’s certainly a number of risks and big macro-economic headlines that have been driving spikes in volatility. So it does feel like it’s a little bit more volatile today.
Ben Jones – Quick update as of the release of this episode the VIX is sitting at historical highs, much elevated from the long-term average. So for the advisors that are listening to us today, why do you believe that they should care about this topic?
Chris Jenks – It’s important for your clients. I think I have a relatively unique position that I sat in those shoes before. We had a number of clients that were in or nearing retirement, they wanted to maintain the same level of income as their working years, and they’re a little scared or hesitant to move to a full retiree position. And low vol is unique in that really, it’s explicitly designed to address that challenge, right. It allows you sufficient upside exposure to equity markets, but with a fraction of the volatility. So I do think that from an objectives-based approach, it is ideally suited for most of the clients that advisors have exposure to.
Ben Jones – If there is lower volatility, even if they don’t reallocate that risk budget, it still allows them to help better manage the behavior of the client in those panic sell-offs.
Chris Jenks – Absolutely, it keeps clients invested, and that is so, so important. We look back historically; missing some of the biggest up days in the S&P 5, have a detrimental impact in your ending wealth. So you want to stay invested and low vol is a way to help manage the behavioral aspects of clients.
Ben Jones – Okay, so we talked a little bit about some behavioral biases and we talked about the glamour effect, but I’ve also heard you refer to this idea that there’s some structural issues that are causing this low vol anomaly. Could you give some examples and kind of define that.
Chris Jenks – Yeah. A great example is some of these structural drivers of the low volatility anomaly would be compensation structures for active managers. Right, so think about it more as an option payout structure, where a manager has their base salary and their upside incentive and bonus pay is going to be tied to shorter term alpha and excess returns. All that’s going to do is incentivize managers to reach for riskier stocks, expecting bigger payouts and driving prices of those riskier stocks higher. So that would be one example of a structural bias. Going back to structures and active management, a benchmark aware and tracking aware world, managers are less incentivized, so hold lower beta stocks. They would rather hold what could be a higher beta stock that may have less alpha potential to deliver returns that are tied to the equity risk premium and ultimately beat that benchmark. So there’s certainly structural issues tied to specifically the active management community, which drive the low volatility anomaly.
Ben Jones – We talk to a lot of advisors and a lot of the folks who have written into this show at times, and talked a lot about this idea of risk reduction.
Chris Jenks – Yep.
Ben Jones – And how do we de-risk portfolios. We’ve got trade wars, we’ve got pandemics, we’ve got elections, et cetera, and it’s easy to see why people are concerned about reducing risk. But, I’ve heard you say that when they’re de-risking their portfolios, they kind of get stuck in this idea of overpaying for defensive equities while still maintaining equities for upside, or getting stuck in that idea of trying to time the market. So, walk me through some of the competing priorities that advisors might face when they’re trying to de-risk these.
Chris Jenks – Yeah, sure. So, de-risking is a complex thing in today’s environment. Typically, investors want to de-risk or advisors want to de-risk client portfolio, you move from equities to bonds and take this expected standard deviation of the portfolio down quite a bit. But, we’re in a low rate environment and you don’t want to sit here and make a call on rates. Doesn’t look like rates are going to move in either direction in a significant manner any time in the near future, and you’re getting a relatively anemic coupon from your fixed income allocation. How do you reduce risk? Low vol offers a very compelling solution, but some of the challenges that advisors have today with just a proliferation of product in this space is understanding what is my manager delivering and what am I getting in my low volatility portfolio. You touch on something that’s very important and relevant in today’s market, just valuations. Investors, since the selloff in 2018, have been positioning portfolios for increased volatility and potential recessionary environment, and as a result, we’re seeing some pretty expensive valuations in traditional bond proxy sectors, or areas of the markets, such as utilities. So it’s certainly a complex exercise in today’s market, and advisors really need to take a step back and understand what are the needs of their clients and how do I effectively reduce risk without injecting other potential unintended consequences or exposures in my portfolio.
Ben Jones – Now that we have a better understanding of the landscape, what are the options for de-risking portfolios and why should low vol be considered over other strategies. There’s a lot of ways you can de-risk portfolios. You touched on the traditional way, which is put more into fixed income from equities, but you can also hedge. Cash is a true diversifier. There’s long, short equities, there’s alts and managed futures. We hear about all of these things today in the marketplace. Compare and contrast using low vol to de-risk versus some of these other strategies.
Chris Jenks – Yeah, I mean relative to cash, it’s pretty straightforward, right, you go to cash, you’re losing an inflation loan right there, even if inflation’s somewhat benign in today’s market environment. You’re still giving away upside potential there, so low vol allows you to reduce volatility with giving that equity exposure some upside exposure there.
Ben Jones – Okay.
Chris Jenks – Relative to — let’s classify alternatives and hedging strategies into one category there. It depends where you’re at in the spectrum and what type of alternative solution you are using. I’ll say we have seen a number of institutional buyers look to low vol as a replacement to their long, short equity portfolio. It came to the realization that you could somewhat replicate that beta exposure at a fraction of the cost, and with greater liquidity. So certainly some benefits there. If you were to look at more market-neutral strategies, they fit two different bills, to be quite frank. What you’re doing is you’re stripping out that beta exposure and you’re lowering correlations to traditional asset classes using market neutral, so there’s certainly diversification benefits there. But again, it’s about balancing the tradeoff between risk reduction, liquidity and fees in delivering a comprehensive solution to your clients.
Ben Jones – In that case, do you think that advisors should be, when they’re building these portfolios, should be using a risk budgeting approach? I have heard more and more advisors using a fee budgeting approach —
Chris Jenks – Yeah.
Ben Jones – — and so maybe it could — do you have thoughts on that?
Chris Jenks – Yeah, that’s an interesting topic. I think if you’re making decisions on fees and fees alone, you could potentially do some harm to your client portfolios. I’ve talked a lot already about some of the flaws in the passive approaches in the marketplace and if you were allocating based on fees alone, you may be compelled to allocate more to a passive solution there that offers risk reduction properties and characteristics. But, feel strongly that you’re not getting what you think you’re getting in those types of strategies there. So that’s a loaded question. I think the risk budgeting approach, low vol is pretty compelling in that, essentially, what it does is it takes your efficient frontier of optimal portfolios, pushes it to the upper-left hand quadrant of the risk/return charts and allows you a more efficient way to allocate risk. So, you could do a couple of different things here and I think it fits the bill across both dimensions, a way to reduce risk and get some lower beta exposure without having to pay big hedge fund fees. Then, from the risk budgeting side, you’re able to deploy that risk budget that you’d otherwise use in traditional cap-weighted equities to other areas of the market.
Ben Jones – I’ve learned a lot about factor-based investing. Everybody’s heard the term, I’ve learned a lot — a lot of what I’ve learned has come from you, thank you. But, I do want to ask a couple questions about low vol, because I think the people listening to this would be really upset if I didn’t ask you these. Which is, how does low vol not just end up being a quality bias?
Chris Jenks – Yeah. So, if you were to look at different quintiles of risk across the marketplace, what you find is the relationship isn’t necessarily in low risk and high quality, you find a strong relationship between high risk and low quality. Right, so you’re not just taking a big quality but in the portfolio, you actually find that those correlations are somewhat modest, so you’re able to diversify your portfolio further by including stocks that are not just low risk, but also low risk that are of high quality.
Ben Jones – Given the amount of money that’s moved into these strategies over the last decade, how is momentum not the factor that’s driven the low volatility.
Chris Jenks – Momentum and risk is an interesting relationship. Momentum is a complex, and when I say momentum here, it’s not just market momentum, right — just looking at returns of previous winners over previous losers, so more of a traditional carved out momentum — you’ll find that momentum can, at times, buy us either a higher or low risk stocks in the market. I think intuitively, that makes sense, right. Investors preference for risk on, risk off could drive price momentum. The thing about low vol and low risk is being that it can have the tendency to buy us momentum that could be an additional source of risk in the portfolio, because momentum as a factor is risky. So I think that’s, again, another reason why you want to a more active approach and have a manager that understands the relationship between risk and momentum, and can successfully navigate those market environments where you see low risk and momentum having a more positive correlation to one another, and look for environments where momentum looks risky from a factor sense.
Ben Jones – How does your team think about risk, valuation, diversification within this low vol strategy?
Chris Jenks – Yeah. So first and foremost, there’s a big difference between a low risk portfolio and a portfolio of low risk stocks. It may seem like semantics, but that’s key and that’s crucial, right. Because when you look at the portfolio level, if you want to effectively reduce risk, it’s more about exploiting correlation structures to reduce volatility, not just loading up on a bunch of companies that have historically exhibited low risk characteristics, whether you’re looking at standard deviations or even a single quantitative risk model. So, that’s definitely important, is how do you look at risk, not just the stock level, just how do you bring it all together and diversify portfolio. In the topic of sector exposures, if your objective is to reduce volatility, that should be completely agnostic to the exposures of the cap-weighted benchmark. So, should I own 20+% technology because the Russell 1 owns 20+% technology, or should I be able to drift away and have more common sense constraints, so it’s a balance.
Emily Larsen – Next, Ben spends some time with Chris on what might be the most important part of this episode, doing your due diligence. Just because something says it’s low volatility, doesn’t mean it really is. So Chris unpacks the hard work of getting to the truth before you make an investment decision. Then, they talk about actions you can take to implement this for your clients.
Ben Jones – So, let’s talk a little bit about there’s a lot of passive strategies.
Chris Jenks – Yes.
Ben Jones – And there’s a lot of cheap replication strategies in low vol. You mentioned — I don’t remember what you said, 200 different strategies.
Chris Jenks – Over different 200 strategies in the Envestnet global universe, yeah.
Ben Jones – Yeah. So let’s just talk, first of all, if an advisor’s trying to decide between the passive and active approach, what should they consider?
Chris Jenks – Sure. So a couple of key things on the checklist to think about. First and foremost, how is this strategy measuring risk? Is it looking backwards at just some historical measure of price volatility or is it using a more complex way to measure and assess risk using a risk model, let’s say? Over what dimensions does it look at risk? Is it a single dimension using a price volatility or even a single quantitative risk model, or is this just multi-dimensional understanding of volatility? The frequency in which you re-balance, that’s also something that’s important. Risk is dynamic, risk could change the marketplace and do you want to be bound to the methodology of an index that may reconstitute once or twice a year, or do you want to have greater frequency in which you could re-balance the portfolio and have that flexibility. Sector exposures and constraints, we’ve already touched on that a little bit, but that’s certainly a big one here. How’s the portfolio constructed, what constraints are in place, how are you effectively managing that tradeoff between constraints and risk reduction? So these are all some common questions that an advisor should ask when kicking the tires on different low volatility strategies.
Ben Jones – I like that. And so, what are some reasons someone might choose one or another?
Chris Jenks – Well, we already touched on fees.
Ben Jones – Yeah.
Chris Jenks – And that’s been a big driver in today’s market. We are increasingly cost sensitive world. I mean, advisors struggle with lowering the fees of their client portfolios, which certainly make those passive solutions look more appealing. But I think, again, at the end of the day is just the robustness of how does this manager think of risk, is there a time tested approach that has weathered different types of market environments? 2018 was a great litmus test. We went through a very long time in equities without a significant pullback and we’ve had a few notable pullbacks here in the last 24 months. So definitely look at how managers have held up during periods of volatility, is this strategy time tested.
Chris Jenks – Are there ways to kind of ensure that you’re actually going to get — I mean obviously, a lot of this stuff is back tested, and I’ve never seen a back tested strategy I didn’t love. But is there an actual way to buy a low vol strategy and ensure that, besides the name, it’s actually low vol?
Chris Jenks – Yeah. Well, I’m going to preface with past results are not indicative of future returns, whatever the compliance disclaimer may be.
Ben Jones – Right.
Chris Jenks – No, that’s the thing is, you want to find managers and strategies that have time tested track records, have experienced periods of volatility, and really open the hood, diving in deep and understanding how the portfolios are constructed. What tools are used, what types of risk models — are there multiple risk models? How does the strategy take into consideration expected return, right? Are you just lowering risk and that’s it, or are you lowering risk but still buying companies that have above average or attractive return potential? That’s certainly something you can do there. Is it a pure quant approach? Quant models and risk models do a really nice job to help you understand risk and volatility. But, like all risk models, there are limitations. So is the approach multi-dimensional, or multi-disciplinary? Does it incorporate fundamental insights? So a lot of things to consider. Really ask the tough questions. Really understand how is risk being measured and how is brought together at the portfolio level.
Ben Jones – For a lot of advisors that are out there that have embraced the idea of low vol, the questions that we hear a lot from advisors, as we talk about these strategies, is that’s great. I understand that, and I understand now how to do due diligence, but what type of investor is best suited to allocate to low vol, and are there different ways or types that you would invest for different types of investors?
Chris Jenks – Yeah. I personally believe that low vol is somewhat of an “all weather” solution, no matter what type of client you’re dealing with. If you’re dealing with somebody that’s a little bit younger in terms of demographics, and their objective is to build, grow, accumulate wealth; well, what low vol allows you to do is lower volatility and redeploy that risk to higher return areas of the market, generating a return for a portfolio that has a greater return without taking a lot of risk to achieve that level of return. If you think about your older demographic that is in or near retirement, it allows exposure to upside in equity markets, but with the downside protection. The last thing you want to do for your clients is expose them to a downside scenario when they’re in the midst of a cash withdrawal, right. That’s the last thing you want to do. You want to be able to participate in those recoveries, so low vol offers you that cushion with still giving you that upside exposure.
Ben Jones – And so, when an advisor is thinking about this, how do you implement low vol as part of a well-diversified portfolio? Generally speaking, advisors make up numbers, 25% of the portfolio in U.S. equities and say 20 is in large cap or something like that. How should they think about this? Does it replace all of your large cap, replace part of it? Where does it fit?
Chris Jenks – I definitely think it’s a replacement to your core equity exposure. If you want to meaningfully move that needle, 5% allocation to low vol as more of a satellite probably isn’t going to do the trick. I definitely think if you want to really take advantage and extract the full benefits of low volatility investing, it needs to be a replacement to your core equity exposure.
Ben Jones – You’re talking about having exposure in your U.S. large caps and maybe 20% to 25% in low vol, or are you talking about 100% of the core equity exposure?
Chris Jenks – Potentially. I think it all depends on the comfort level of the advisor, and the comfort level of the client. Yeah, definitely. I think the benefits are there, the more exposure you can get the better for your client portfolios.
Ben Jones – When we get a big falling out, what are some of the risks that are in these low vol strategies that advisors might not be paying attention to or aware of?
Chris Jenks – Yeah, the risk is that you don’t hold up in that downside, right, and something that’s intended to deliver 40% to 50% downside protection is giving you more like 90% to 100%, right. That’s the risk that you introduce to your book of business. You put something in the client portfolio and sell them the expectations of downside protection, and that’s just something you simply don’t get.
Ben Jones – So how can advisors ensure or sort out which managers really have that experience with managing that downside, or a track record of managing the downside versus things that are called low vol and when things go south, it ends poorly?
Chris Jenks – Just because there’s low vol and mid vol, defensive in the name doesn’t mean that it’s low risk or a low volatility portfolio. So I think it really comes down to the quality of the process, and just the humility of the manager to understand that this is a challenging exercise. Risk is complex, risk means may different things, and that you’re looking at it the right way.
Ben Jones – Is there a particular thing they could look at from a statistics standpoint to help them?
Chris Jenks – Yeah, look at the draw down metrics, right. Means a lot more than just standard deviation. Look at max draw down, look at upside/downside tradeoff, downside capture is certainly something that’s very important to understand when you look at low volatility portfolios.
Ben Jones – One hesitation you might still have: Is there a scenario in which low volatility anomaly goes away?
Chris Jenks – I think one question that gets asked a lot is what’s going to stop this from going away? This is great when I look over long data sets, but could the low vol anomaly get arbitraged away at some point? The answer is no. Behaviorally, we’re not going to change. There are some structural reasons. Again, really drilling into the marketplace and the product that’s available out there today, not all low vol is created equal, and there won’t be a full crowding out effect of this anomaly. It will certainly persist.
Emily Larsen – Thank you to Chris Jenks for joining us to discuss this timely topic. Evaluating these strategies requires understanding of what to look for and how they fit into a well-diversified portfolio. We hope this conversation enhanced your knowledge on the topic. In closing, we asked Chris for a warning label he would attach to this episode.
Chris Jenks – Investors have begun to embrace the benefits of low volatility investing, but with this we’ve seen a proliferation of products. I think it’s important to understand that not all low volatility is created equal; to really dive into some of the differences and how different strategies are constructed.
Ben Jones – Thank you for listening to Better conversations. Better outcomes. This podcast is presented by BMO Global Asset Management. To access the resources discussed in today’s show, please visit us at www.bmogam.com/betterconversations.
Emily Larsen – We love feedback and would love to hear what you thought about today’s episode. You can send an e-mail to [email protected]
Ben Jones – We really respond.
Emily Larsen – We do!
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Emily Larsen – And I’m Emily Larson. From all of us at BMO Global Asset Management, hoping you have a productive and wonderful week.
Disclosure – The views expressed here are those of the participants, and not those of BMO Global Asset Management, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward looking statements. Investors are cautioned to not place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only, and does not constitute investment, legal, or tax advice and is not intended as an endorsement of any specific investment product, security or service. Individual investors are to consult with an investment, legal, and/or tax professional about their personal situation. Past performance is not indicative of future results. Please note the term de-risk does not mean no risk, all investing involves risk, including the potential loss of principal. Market conditions and trends will fluctuate. The investments and investment strategies discussed are not suitable for, or applicable to, every individual. There is no guarantee that any investment strategy will meet its objectives. The VIX Index refers to the Chicago Board Options Exchange Market Volatility Index and is a measure of implied volatility of S&P 500 index options. The S&P 500 is an unmanaged index of large-cap common stocks. Investments cannot be made in an index. BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. BMO Financial Group is a service mark of Bank of Montreal. Further information can be found at www.bmogam.com.