By Jack Forehand, CFA (@practicalquant)
Anyone who reads my articles regularly knows that I am a big user of Twitter. Some of the best investors in the world regularly post to the platform and it is hard for me to describe the amount I have learned from using it.
My favorite people to follow on Twitter are those who make me think about things in different ways than I currently do. One person who certainly fits that bill is Lawrence Hamtil of Fortune Financial Advisors. His work has helped me to refine my thought process in many areas. For example, it helped me see how much of the underperformance of value investing in recent years can be explained by the sector bets inherent in the strategy. He has also taught me a lot about low volatility investing, which is the factor I know the least about.
In this interview, we will cover those topics, as well as several others that might make you challenge what you think about some popular investing topics.
Jack: Thank you for taking the time to talk to us.
One of the biggest lessons I have learned from following your research is the importance of sectors. If you look at the major trends in the stock market at any given time, there is almost always a sector-based story behind the scenes that explains them. For example, many investors talk about how value investing has not worked in the past decade, but most do not understand that the differences in the sector breakdown between value strategies and the market as a whole can explain a lot of what has gone on.
One of the questions that value investors struggle with is whether overconcentrating your portfolio in a sector that is cheap is worth it. In the past decade, overconcentrating in Financials and underweighting Technology, like most value strategies have done, has certainly not worked. But there is an argument to be made that if you want the strongest exposure to the value factor, you need to buy what is cheap, even if that means an overconcentration in a certain sector or industry. How do you look at this balance between following a factor like value wherever it takes you vs. the risk of overconcentration in specific sectors or industries?
Lawrence: Thanks for having me!
I deal mostly with retirees who are not necessarily looking for the highest possible return regardless of volatility, but who are instead looking for a steadier stream of returns with lower tracking error. I think it was Cliff Asness who said that the best investment strategy is one you can stick with, and so in that sense, a value-oriented strategy that is designed to reduce tracking error – and, therefore, reduce the likelihood of abandoning it in a down period – is optimal. Given this, I prefer a sector-neutral approach that essentially favors the most attractively valued companies in a given sector, but the overall sector weightings of the portfolio more closely resemble those of the market.
Jack: Low volatility is the factor that investors often have the hardest time wrapping their arms around. We were all trained to believe that greater returns require greater risk, but low volatility turns that on its head. At the very least, the evidence suggests that low vol stocks produce comparable returns with less risk, and the evidence is actually pretty compelling that they outperform the market.
One of the more controversial debates in the space has been whether those excess returns require that the factor be coupled with value. I was listening to an interview with Larry Swedroe on Resolve Asset Management’s podcast and he made the point that his research shows that the low volatility factor only works when it is cheap. Research from others like S&P has concluded that it works independent of valuation. Since you have done a lot of work on low volatility investing, I wanted to get your opinion on this. Do you think low vol only produces excess returns when it is cheap?
Lawrence: This is a pretty complex question, and I must stress that I am by no means an expert in this area. Pim van Vliet, Cliff Asness, and others have studied this topic and as far as I can tell, low volatility works best when it is cheap, but that even during periods when it is not cheap, it does not fare significantly worse than the broader market. Of course, any portfolio should do better when it is cheap, but valuation-based ‘timing’ of low volatility stocks is tricky as the periodic rebalancing of the portfolios means that the components are constantly in flux, so the initial valuation seems to be of limited utility for investors.
Jack: Global diversification has been a significant source of debate in recent years. On one hand, the theory of diversifying across countries and regions makes sense. If you expect the US and the rest of the world to produce comparable returns over time, but do so in an uncorrelated manner, then owning both should lead to a more optimal portfolio. But on the other hand, global diversification hasn’t worked for a long time and many argue that there are reasons to believe that the US will continue to outperform the rest of the world. You wrote an excellent post in March that showed that global diversification hasn’t really been helpful for decades and I was wondering what you think about its outlook going forward. Do you think global investing is still worthwhile for US investors?
Lawrence: In my opinion, global diversification is a good thing, but I don’t think most investors approach it the correct way. A few years ago, I argued that the U.S. market is unique in terms of its diversification across industries and sectors, as well as in terms of its dynamism. In contrast, most foreign markets are heavily concentrated in a few sectors (typically financials) if not a few companies, and the lack of dynamism means that investors are typically betting on the same horses as they have been for years. Additionally, shareholder value creation takes priority in the U.S., which is not necessarily the primary consideration of executives in other markets. Even so, diversification abroad is useful in terms of hedging against a decline in the dollar, as well as reducing the risk of being overly exposed to one economy or political system. Admittedly, America has had it so good for so long that the last two benefits of global diversification seem a stretch, but one never knows.
So, that begs the question – how should one approach investing abroad? Personally, instead of diversifying using global market cap weights, I think one useful strategy would be to create a global portfolio based on sector weights, but filtering by value, quality, etc. There are tremendous opportunities abroad, but it seems that the generic foreign stock market indices unfortunately expose investors to the less desirable corners of those markets, and that is reflected in the poor risk-adjusted returns of the generic global portfolio.
Jack: You wrote an interesting thread on Twitter recently about the use of the forward PE for market valuation. The forward PE has always been interesting for me both from an overall market and individual stock perspective. Most factor investors tend to avoid it because analysts are notoriously inaccurate in their earnings predictions, which makes the metric difficult to rely on. But on the flip side of the coin, it is the only popular valuation metric that incorporates estimates of the future, and the value of stocks is a function of what is going to happen in the future not what has happened in the past. Could you talk a little about your thoughts on using forward PE both from an overall market and individual stock perspective and if you think it offers value to investors?
Lawrence: In this case, I have been influenced by Dr. Ed Yardeni’s work (see here, for example). Dr. Ed points out that while it is true that analysts tend to overestimate future earnings, thus making stocks look cheaper than they really are, trailing PE can make stocks look expensive too early in a market cycle. As presented in the thread I posted, some data show that forward PE has recently been more useful than other metrics as a predictive tool, so I think it is unwise to disregard it. For me, it is simply one of many tools that, when used in combination with others, should lead to more useful analysis than any one metric alone would.
Jack: One of the more interesting areas you have looked at is the combination of low volatility with momentum. You wrote a post in 2018 showing that a barbell portfolio combining the two factors outperforms the market while also taking less risk. On the surface, combining momentum and low volatility stocks could seem counterintuitive because they are in many ways the opposites of each other. But that lack of correlation actually proves to be a significant positive. Can you talk about the concept of combining low volatility and momentum and how it could be beneficial to a portfolio?
Lawrence: Over periods of time, factors can go in and out of favor, so a blending of them can lead to a smoother and superior risk-adjusted returns. As you mentioned, the low correlation of low volatility and momentum makes them a good complement for each other, and the data suggest that a simple barbell approach can enhance a portfolio that relies on just one factor or the other.
To show this effect, I ran a test where I subtracted the overall market’s (the S&P 500) return from both a momentum and low volatility strategies’ to see when each strategy would have been both outperforming and underperforming.
These wide divergences seem to suggest that a pairing of the two strategies would have yielded substantial benefits over the period observed. When comparing the two series to a 50-50 low volatility / momentum “barbell” (rebalanced annually), we can see that such a strategy would have captured a decent amount of the outperformance of each individual strategy without suffering as many periods of somewhat steep underperformance.
Obviously, these results are merely hypothetical, and past performance does not guarantee any future success. However, the results seem compelling enough to explore further, especially now that investors can access these strategies easily via low-cost ETFs that can be rebalanced simply and cheaply.
Jack: Thank you again for taking the time to talk to us today. If investors want to find out more about you and you and Fortune Financial Advisors, where are the best places to go?
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