As Sam Sees It: A Strategy for Risk-Tolerant Investors

Sam Stovall |

s&p 500 annual return, risky strategies for investing, investing in high risk stocks, low volatility stocks Each week, we tap the insight of Sam Stovall, Managing Director of US Equity Strategy for S&P Capital IQ, for his perspective on the current market.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

EQ: Fed Chair Janet Yellen held her second press conference Wednesday, and it seems the market was satisfied with the central bank’s latest policy statement. Were investors encouraged by the Fed’s decision to maintain its tapering?

Stovall: I certainly think so based on the initial action of the S&P 500 immediately after the Fed statement had been released. So even though there was the prospect that the Fed may start its rate tightening program a little earlier than anticipated, I think the hint that they would still keep rates relatively low resonated well with investors.

EQ: Interest rates have not really reacted the way most experts thought they would heading into this year, but the Fed stated that they expect interest rates to start increasing faster going forward—especially in 2015 and 2016. Could we potentially see a catch-up effect that may surprise complacent investors?

Stovall: I think that’s possible. Certainly the trajectory of rates is higher over the next 12 to 18 months. I think there was definite reason for rates to decline here in the U.S. during the first six months of the year. First off, we had such an outperformance of equities in 2013 versus bonds that a 60-40 portfolio became 67% stocks and 33% bonds by the end of the year. So just a natural rebalancing brought back interest into the bond market.

Also, with the economy looking so weak early into the new year because of bad weather, I think investors wondered whether it was weather alone that really caused the economy to slip. Investors are also looking at the economic data, which is coming in a shade weaker than anticipated—in particular, housing starts and retail sales. As a result, they may be wondering if rate increases will be as aggressive as some people worry they will be.

So over the long term, I think the trajectory is higher for bond yields, but the slope of the increase in interest rates will be a bit more muted.

EQ: In this week’s Sector Watch, you dug into the High-Beta and Low-Volatility indices risk indicator that we discussed a few weeks ago. The focus was on the performance of the “tails” of these indices. What’s the rationale in doing this in the first place?

Stovall: I think the reasoning is if you are gravitating toward either the High-Beta category or the Low-Volatility grouping, in a sense, you are looking to extremes. The premise was if you get rid of the middle stocks, which are more hybrid-like, and focused on the pure higher beta and lower volatility equities, then maybe you can get the best of both worlds.

You may be able to get a higher optimum return from the High-Beta stocks but also have the lower volatility groups sort of neutralize the higher volatility.

From Dec. 31, 1991 to June 13, 2014, the S&P 500 has averaged an annual total return of 10.1%, and the 50/50 High Beta/Low Volatility strategy had a total annual return of 11.2%. So while it did perform better, the problem was you also increased your volatility as compared with the S&P 500 by itself. So as everything with life, there are choices to be made.

You may be able to get a higher return by focusing on the tail ends of the S&P 500, but in order to get those higher returns, you also have to accept higher risk.

EQ: How much higher was the risk-to-reward profile for this strategy?

Stovall: There are two ways of looking at that. First off, what was the drawdown during the bear market of 2007 through 2009? Instead of declining about 50% on a month-ending basis for the S&P 500, we ended up declining close to 60% for this 50/50 combination of High Beta and Low Volatility.

In addition, when looking at month-ending data, I found that the overall standard deviation (measure of volatility) was about 20% higher for the 50/50 portfolio when it was for the S&P 500 as a whole. So in general, no matter which way you slice it, you did end up experiencing a lot more volatility at some point in time, especially during the most recent bear market.

EQ: Investors may also have to deal with some unintended consequences with this strategy in regards to the sector weighting, correct?

Stovall: That’s right. If you are focusing on the 100 stocks with the highest volatility and the 100 stocks with the lower volatility, and thus, eliminating the 300 stocks in the middle, it should come as no surprise that you end up with an extreme overweighting of particular areas.

More specifically, you’d have extreme overexposure to Utilities (+295), Materials (+119%), and Industrials (+45%), and extreme underexposure to Health Care (-48%), Information Technology (-68%) and Telecom Services (-82%).

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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