In these excerpts from a recent Webinar, Harin de Silva, Ph.D., CFA, and President of Analytic Investors sits down with Tom Florence, President and CEO of 361 Capital and answers questions regarding Markets, Volatility and Long/Short Investing.
Harin de Silva, Ph.D., CFA, President, Portfolio Manager
Analytic Investors, Sub-Advisor to 361 Global Long/Short Equity
Q: 2015 was a challenging market environment for investors and certainly advisers and their clients. What do you anticipate for the markets in 2016?
A: My belief is that 2016 is going to be similar to what we experienced in the latter half of 2015…[expand title=”Read More”]because if you think about…I actually think of 2015 as two distinct time periods, because until August things were actually very quiet. And then, volatility really, really picked up.
And I think as we go into 2016, we need to keep in mind that we’re around 70 months into an economic recovery. We’ve lost the ability of the Fed to intervene to kind of save the market. I think the Fed is pretty much committed to raising rates.
So, I think those two things combined, to me, signal that we’re going to see more normal levels of volatility. So, volatility around 20%, going up to 25%, and then down to about 18%, or so. Very similar to what we’ve experienced in the first three weeks of January this year. [/expand]
Q: It is a very different time period now than we’ve seen, with the exception of maybe 2008, advisers are trying to figure out, “Exactly what should I do with my portfolios? What should I be telling my investors?”
A: Right. And this is sort of the new normal, right?…[expand title=”READ MORE”] The long-run level of volatility in the market is 20%. It’s not the 10%, 12%, 15% we’ve experienced on average over the last five years.
So, I think as investors look at this market, they really need to think about the fact that, “Yes, in the 20% market where valuations are stretched, where can I get returns from?”
And what I tell people to do is remember that you’ve got lots of way to generate returns in your portfolio. You can have a valuation tilt. You can have a quality tilt. You can have a low-beta bias. It’s not just all about equity market risk. There’s lot of other ways you can generate return for your clients.
So, when you think about designing a portfolio, think about having those other components come into the portfolio so that they have multiple sources of return. [/expand]
Q: As we look at this environment right now, does it really make the case for long/short investing and, specifically, investing in long/short equity?
A: For me, actually, that’s a question and the answer is almost always “yes,” because I think long/short is almost always a good thing to do because…[expand title=”READ MORE”] when you are shorting you are able to capture a lot of the anomalies in the market that aren’t as prevalent on the long side. It gives you a lot more ability.
For example, if you look at the market right now, there’s a general view that the market is overpriced, or at the high levels of valuation. And long/short managers have the ability in that environment to short expensive stocks and therefore have a value-bias in their portfolio.
A general long-only manager, the only thing you can do is buy cheap stocks, and everyone is already doing that. So, if you look at the distribution of valuations in the marketplace, there aren’t that many inexpensive stocks. If you look at a low-beta portfolio, for example, it’s actually already very expensive.
But having the ability to short really gives you additional levers you can pull that you can’t do in a traditional long-only portfolio.[/expand]
Q: You [and Analytic Investors] have done an enormous amount of work about investing in low beta versus high beta and shorting high-beta stocks—how over time low beta outperforms high beta. And that’s really a critical element to how you invest.
A: What we found is that if you looked at relatively long horizons — so, anything more than about three years, on average — if you look at a portfolio of high-beta stocks…[expand title=”READ MORE”] they tend to underperform the market. And if you look at a portfolio of low-beta stocks, they tend to match the market return, or slightly exceed the market return.
So, that’s why we are a big proponent of having a position in high-beta stocks where you actually short those stocks in your portfolio, because what that does is, is it dramatically reduces the volatility of your portfolio. And yet, it has a very low cost, because the expected alpha of a high-beta portfolio is negative. So, if you short something with a negative alpha, you’re actually generating returns by having that short position in your portfolio.
And we’ve seen this in small-cap stocks. We’ve seen it in emerging market stocks. We’ve seen it in U.S. stocks. And we’ve seen it in global, pretty much across the world. So, it’s an anomaly that’s prevalent everywhere. It’s not something that’s a function of a particular time period or a particular market. And that’s why we are such believers in having a low-beta tilt in your portfolio. [/expand]
Q: If you look at 2015 in particular, you had some significant wins in the sector areas. Let’s talk about sectors: wins and losses.
A: So, the big contributor last year was the short position we had in energy. We started the year with about a 14% short position in energy. We ended the year with…[expand title=”READ MORE”] approximately 11% short position in energy. So, as energy stocks went down, they weren’t that attractive from a valuation standpoint. Their beta actually dropped a little bit. And we shifted the portfolio towards the healthcare sector and also the banking and financial sector where we had seen a rise in the beta of those stocks.
But that was a huge contributor in terms of return.
I think the other big contributor last year to return was — and this is on a risk-adjusted basis — the position we had in the consumer staples sector, and that was about 10% of our portfolio. We also had a pretty good position in consumer discretionary. And both of those sectors actually did relatively well.
So, overall, I think those would be our big winners in terms of contributing things to the portfolio. [/expand]
Q: The strategy had big success in shorting energy. There could be a quick reversal there. What’s to prevent the strategy from experiencing some challenges as sectors rotate?
A: Part of what we do in this strategy is look at the shift in risk on a daily basis. So, typically, what happens is if you follow a particular sector over time…[expand title=”READ MORE”]what you’ll see is that if it’s a high-beta sector, as it does poorly, the valuations tend to get more attractive and the volatility of the sector tends to drop.
And at that point, you can actually — you need to actively reduce your allocation to that sector, which is what we are doing in the energy sector in the portfolio. So, I think you are going to see this allocation in the short position actually decline over the next three months, or so.
And that’s why it needs to be an actively managed strategy, where you’re not continually just maintaining passively a short position, because the beta of sectors sort of changes over time. And what we really rely on is the risk budgeting process that we use, where we are looking at these sectors, we are looking at their betas and their riskiness using two different risk models, also looking at implied volatility from the options market. And those are some of the tools we are using to actually hedge against the potential whipsaw when that sector comes roaring back. [/expand]
Q: While we’re talking about sectors, the same could be said of economic trends contributing to being a high- or a low-beta stock, correct?
A: Right. Right. So, you could have, for example…right now the other high-beta sector is materials, given the global slowdown we are seeing…[expand title=”READ MORE”] You could see — if there is a strong recovery either in EM or a continued strong recovery in Europe, where there’s more of a manufacturing sector, you could see materials take off in terms of beta. [/expand]
Q: Let’s talk about valuations in low-volatility stocks as it sits today from your perspective—and that process in both the world and domestic markets.
A: People always ask us the question, “Hey, you guys are quant guys. What do you do all day? Do you just sit around and play golf, or something?”…[expand title=”READ MORE”] And we really don’t do that, because our view is that you really need to continuously improve your research process. So, we spend a lot of time looking at different ways we can improve the risk model, ways we can improve our return forecasting model.
As a firm, we are committed to a dynamic equity valuation process, where we look at what characteristics are driving markets and then use that to build a portfolio. So, for example, if you look at our portfolios right now, we have a very, very strong quality tilt in the portfolio. We have a…that typically has worked well based on our models in the later stages of economic recovery.
Value tends to be important but less important. We look at differentials in valuation on the long and the short side, which is actually quite different, and that’s something we’ve incorporated in our process over the last year, or so.
So, very much committed to improving the process, as opposed to just running the same system or same process over and over again, because our view is if you’re not evolving, you’re not growing. [/expand]
To hear the full webinar, you can view it here.