Investors bracing for higher interest rates have been
shunning U.S. Treasuries and snapping up alternatives such as
bank loans and high-yield corporates, which tend to be more
responsive to improving economic conditions than to rate
changes. But this strategy may also expose such investors to
market sensitivities that they did not think were part of the
deal. Theres another way to go.
Weve written before about how a
strategy targeting stable, high-quality business models
handles a variety of investor needs. It can smooth performance
while capturing the long-term returns from equities more
efficiently, or it can act as a third dimension of investing
style uncorrelated with other active approaches, such as value
and growth. But there is another use you may not have thought
of: harvesting just the potential for return associated with
high-quality, less volatile stocks by eliminating exposure to
stock market fluctuations.
To understand the appeal of such an approach, recall that a
portfolio of stocks screened based solely on their sensitivity
to the market produced very attractive long-term returns.
Sorting that same group for traits of strong fundamental
quality such as robust free cash flow generation,
sustainable competitive advantages and good capital stewardship
generated even better results,
as weve noted.
To extract this alpha potential, we hedge out the portion of
the strategys returns that is associated with equity
market participation. By shorting the market index in
proportion to the portfolios below-market beta, its beta
goes to zero, effectively untethering it from equity market
The results are encouraging. In simulations going back to
1990, a hypothetical high-quality, low-volatility portfolio
with no exposure to the market performed better than government
bonds with similar risk and was far less volatile than
high-yield credit. The end result was a risk-adjusted return
superior to both (see chart 1).
But the true beauty of this absolute-return equity strategy
lies in its diversification benefits within a total portfolio.
These pluses stem from the fact that the sources of long-term
returns of a high-quality, low-volatility equity portfolio
in particular, stable and sustainable profitability
tend to be very different from those of most bond
strategies, whose returns are driven by interest rate levels
and more economically sensitive credit fundamentals.
To illustrate, we have compared the three-month performances
of government bonds; high-yield credit; and a hypothetical
high-quality, low-volatility equity portfolio in different
interest rate and stock market environments since 1990. The
equity portfolio outperformed government bonds in rising and
stable interest rate environments, with similar insensitivity
to rates as high-yield credit. Unlike high-yield credit,
however, this portfolio was also relatively insensitive to
equity market fluctuations, resulting in better downside
protection when equity markets slumped (see chart 2).