Wear your seatbelt as market volatility returns

-- | 24/07/2018 Text size Decrease

Olivia Engel: Sure. I think active quantitative investing means different things to different people. But to us, there are three main pillars of what it means. So, the first one is, firstly, about being active. So, active means seeking alpha, seeking excess returns wherever we can find them because we know that there are inefficiencies in the market everywhere. The second thing is about the quant side. So, this is about using market breadth to its fullest advantage. So, it's finding ways of objectively measuring expected returns, finding ways to help you measure things that enable you to forecast expected returns over thousands of companies, so you can really preserve the breadth that the market offers you and keep your expected returns objective in the way that they are measured. The third thing that's really important is that actually when it comes to forming expected returns about companies, it has to make intuitive investment sense. It's not just about statistical relationships between input data and stock returns. It's actually about fundamental characteristics that we like about companies that would make sense to any investor. So, quality characteristics, balance sheet quality, earnings quality, solvency, valuations. So, what valuation metrics can we use to evaluate, and form expected returns. These are fundamental ideas that matter, and they always have to take front stage prominence when we are coming up with ways of forecasting stocks. Yes, I love that analogy in thinking about protecting yourself from volatility. It's very difficult to know when volatility events happen. I mean, the reason markets react the way they do when events happen is because they didn't see it coming. It's just like if you are driving you don't wait until you are about to have an accident to put your seatbelt on. You wear it all the time. So, cushioning your portfolio from market volatility, I think, has evolved over the years because of the macro environment we are in. So, if I just draw on the kind of macro environment we've been in since the global financial crisis, we've been in one which has been very tentative economic growth. And in an economic downturn period, traditional defensive parts of the market look like utilities, real estate, infrastructure, consumer staples. Those types of industries are really very defensive when there's an economic downturn. But looking down the barrel about macroeconomic cycle would come, we are looking at an environment where there could be inflationary pressures, where interest rates are starting to rise and might do so over a number of years. And so, what it takes to be defensive has really changed versus history. So, if you think about the exposure to inflation risk, you really need other types of exposures in your portfolio such as cyclical exposures, maybe from the technology sector in global equities or you might need some exposure to real assets mining companies which are very good at protecting against inflation. From the perspective of rising interest rates, having some exposure to financial companies that are positively leveraged to a rising interest rate environment is also an important balancing act with some of the more traditional defensive exposures. So, if you have exposure to banks, some insurance companies, that can help you in a period of rising interest rates. So, we've designed a strategy which both looks to perform strongly in all different market environments, but we also are trying to achieve a lower volatility profile than the market offers because equities is a risky asset class. So, if we can reduce the volatility for our clients, that helps them to benefit from compounding. If markets fall less, then when markets rebound, you get the benefit of compounding. So, the way we do that is to both assess individual stocks from an expected return context. So, we are looking for cheaper companies, high-quality, strong balance sheets improving earnings, but we also estimate how volatility we expect companies to be. And so, if there are two companies with an equal expected return, we will prefer the company which has a lower expected volatility. And when you put companies together into a portfolio context with that goal, you can end up getting a lower volatility profile than the market overall. And so, if we do get a market downturn where there's an economic decline below expectations and the market falls as a result of that, then having this focus on volatility in addition to return, we can lower the expected drawdown or negative return that the market might have for investors and that's certainly what we are aiming to do. We are looking for a smoother return profile, as smoother return profile as possible. And there are a number of companies out there when you look for those ingredients which are strong margins, improving outlook, strong balance sheets, cash flow, reasonable valuations, coupled with expected volatility being lower, you can really find companies that exhibit that profile that we are looking for.