By Jonathan White
Following a turbulent start to 2016 our view remains that ‘quality’ should continue to be an important source of return this year. Year to date, quality has been rewarded in line with our expectations and we still expect global earnings to remain in ‘expansion mode’, but with the rate of growth at a modest 3%.
At the end of last year we suggested that 2016 would see a continuation of a late-cycle expansionary environment, which meant that global corporate earnings would still grow, but with the rate of growth slowing. For smart beta investors we highlighted that in such a market environment we expected quality factors to outperform. This is because when growth becomes scarce investors typically reward higher-quality equity due to its ability to generate stable earnings growth.
This pattern of behaviour for the quality factor is something we have observed in each earnings cycle since 1990. However we also warned that bouts of market-wide volatility were likely given rising macroeconomic risks and, as such, smart beta investors concerned about downside risks should retain exposure to low volatility factors.
The standout factor in early 2016 has been low volatility; this factor was particularly strong in January as equity markets sold off given fears around global growth. Strong performance from low volatility during a period of risk aversion is of course no surprise, with low volatility delivering on its expected attribute of mitigating market downside.
Perhaps more surprising has been the strength of low volatility factors over the last two years during a period when markets overall have delivered strong returns. In part this longer term performance can be ascribed to strength in a number of defensive sectors, such as consumer staples, and weakness in more volatile commodity sectors.
Our fear today with respect to low volatility is that the strong performance, combined with a growth in popularity of this factor, has resulted in some segments of low volatility equity becoming expensive.
In our view, low volatility approaches that only focus on price volatility without any consideration of earnings or valuation are the most vulnerable – for example minimum volatility indices and the ETFs that track them. While such indices have performed well they have also in our view become significantly more expensive when looking at the Price-to-Earnings Ratio (P/E). Based on our analysis, the P/E of a minimum volatility strategy has risen from 17 times at the start of 2014 to close to 23 times today. The valuation today represents a 24% premium to the market. We think this valuation is a consequence of both a process that does not consider earnings or valuation combined with the significant asset flows these approaches have attracted in the recent past.
We should stress that not all low volatility equity strategies are expensive; investors concerned about ‘downside’ risks can still obtain exposure to low volatility at a reasonable price. However, to do so it could be wise to avoid simple index-based approaches and potentially adopt a strategy that avoids the most expensive low volatility names and is sufficiently diversified to mitigate crowding risks.
Furthermore to help navigate a full market cycle we believe smart beta investors should avoid a dependency on a single factor and instead adopt a blend of more than one factor. One option investors could consider is an approach that incorporates earnings quality. Our analysis of the earnings cycle shows quality has defensive features that complement low volatility when markets are distressed, yet also helps capture upside during rising markets as quality provides an anchor to growing earnings.
By understanding the relationship that risk premia have with the earnings cycle a smart beta investor can improve upon the risk and return outcome offered and design the type of risk premia blend that best meets their long term investment goals.
Jonathan White is deputy head of client portfolio management at AXA IM Rosenberg Equities
