What a difference a few months and a U.S. presidential election make. In August, we wrote about the enormous amount of money flowing into “low volatility” ETFs and the associated risks they carried. Bond yields were very low or negative and investors were seeking yield generating investments that were perceived as safe.
At that point in time, investments (predominantly ETFs) with the words “Min Vol”, or “Low Vol” were getting billions of dollars of inflows. This tidal wave of capital flowed into the stocks these ETFs hold. The consistent buying of these perceived “high quality” and “low risk” stocks further increased the multiples of this already expensive group of investments. While many of these companies are in fact very high-quality businesses, we became increasingly concerned that valuations were getting stretched. Furthermore, that the potential risks outweighed the possible rewards. We found this troubling, because the very investors who bought them were doing so because they believed these investments to be low risk.
With the recent shift in investor sentiment from concerns around deflation to now potential reflation, there has been a drastic change in momentum across sectors. Many sectors which were leaders in a “lower for longer” interest rate world have quickly seen their fortunes reverse. These stocks are also among the largest holdings in numerous “low volatility” ETFs mentioned in the August post as having stretched valuations.
Since our blog just over three months ago, a prominent “Low Vol” ETF in Canada and the U.S. is down -6.3% and -8.9% respectively, while the TSX and S&P 500 are both positive. This seems to be a large absolute and relative decline for a product marketed as “low volatility”. This goes to show that it is not the name of an investment product that determines the risk, it is what the ETF or mutual fund holds!
On the flip side of the coin, there are many high-quality (albeit cyclical) businesses which we believed were attractively valued that were not considered traditional “low volatility” stocks, and therefore these did not receive the same level of ETF/Index buying. We owned many of these companies along with higher levels of cash as a buffer. We have seen the market shift from the very crowded low volatility names to those that would be better suited to a different (and opposite) world.
We are pleased to see this rotation occur as we at Cambridge employ a consistent, bottom up investment process and we believed the names we owned had a positively skewed risk / reward balance. As the low volatility momentum trade unwinds, we are seeing the market take a greater interest in many securities we believe have been mispriced.
As always, we will continue to operate using our consistently applied risk / reward framework to build portfolios. We believe that periods of volatility and lower overall correlations, like we find ourselves in today, create opportunities for stock pickers.
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