Using a Low Volatility Equity strategy, investors can capture three types of potential benefits. They are:
- Downside protection
- Improved return potential
De-Risking – For a risk-averse investor, it’s important to guard against adverse economic scenarios, while keeping an eye to upside growth. Low-volatility assets can help accomplish this dual-mandate by keeping the range of expected returns within a relatively tight bandwidth.
Downside Protection – By de-risking the portfolio early, investors can limit their drawdowns in the aftermath of a market correction, forestalling one of biggest drains on long-run returns.
Improved Return Potential – Low volatility portfolios can help investors achieve higher return potential in two ways. First, they have historically provided higher returns over the long run through the mechanisms described above (harnessing the low volatility anomaly and improving returns via compounding). Second, they allow investors to build higher return potential portfolios by reducing risk in core asset classes and allowing larger allocations to higher risk, higher returning asset classes.
Case Study: An Overview of FAANGs’ Risks
Although we refer to FAANGs as a collective, there are important differences between its constituent members.
We hold shares in Apple because of their stable cashflows due to a loyal and captive consumer base, wide margins, generous dividend policy, brand power, significant cash reserves and rigorous attention to product quality that instills confidence in their ability to continually generate high-quality earnings.
Facebook and Google, meanwhile, derive cash flow from advertising revenues rather than hardware sales. It is difficult to pin appropriate valuations on them, considering uncertainty around the sustainability of their advertising models in light of privacy and regulatory concerns. For example, the implementation of the General Data Protection Regulation led to negative user growth for Facebook Europe, and several EU bodies fined Google for promoting products through its proprietary search engine.
Investors appear indifferent to the possibility of antitrust actions being levelled against Amazon, or there being material changes to shipping prices, global supply chains, cybersecurity conditions, and so on. We believe Amazon is a great company, but view valuation risk at 110 times forward earnings, which makes it unsuitable for this strategy.
Similarly, for Netflix to justify its forward P/E ratio of 137, management would either need to execute a flawless margin-expansion plan, raising prices on consumers without relinquishing market share, or else continue down the path of rapid international expansion.
Ultimately, we believe that many technology stocks only gained low-volatility status through some degree of investor complacency, at a time when loose monetary policy was driving market gains.
Corrections have already begun – Facebook’s share price dropped in excess of 20% after revealing that user growth had faltered in the second quarter, and would likely continue to slow; Netflix plunged by double-digits for nearly identical reasons; and even Google’s seemingly invulnerable valuation sustained short-term damage. That Apple continues to prosper is a positive for our low-volatility strategy.
However, our position in Apple remains under 2% of total assets, meaning we continue to underweight the technology sector, not only in comparison to the S&P 500 index, but also to other low-volatility strategies.
Why Low-Volatility Poses a BIG Opportunity
Classic finance theory, for all its wisdom, makes a bold and somewhat dubious claim in its depiction of the risk-reward relationship. It tells us that increased returns come at the expense of greater odds for failure, in an almost one-to-one equation. Market inefficiencies prove otherwise – and decades of ground-breaking research show that lower-risk securities can outperform by levering cognitive biases.
To put it in perspective, consider two hiking trails that meet at a common juncture. One goes through hilly terrain, where you’ll waste energy on steep inclines and declines; the other follows a gentle slope, which you can manage with ease and confidence. Most people would choose the latter, for efficiency, and to preserve their energy.
Even if you are not wholly committed to the strategy, hedging against your optimism is always a prudent decision. It’s possible FAANGs will evolve into secular utility stocks, channeling cash flows into your portfolio, compounding those returns quarter after quarter, until you trounce the S&P 500 index.
But are you willing to take that bet without covering your downside risk? We certainly aren’t – knowing the extraordinary power of our brains to rationalize desire via the “lottery effect,” we prefer to base our investments on the proven track record of the low-volatility anomaly.