Michael: Equities are the riskiest after class in terms of volatility, but they often lead to higher returns. After equities, you get fixed income, then you get cash product like money market fund GICs or savings accounts.
Chiara: Good day, everyone. Welcome back to another episode of the ETF Experience podcast powered by TDAM Talks. How does one protect their portfolio from the unexpected? Well, today we'll be taking a closer look at a key piece of the investment puzzle how to de-risk your portfolio. We'll reveal how low volatility equities can help you right up market storms while staying on track with your financial goals.
We have an exciting guest for you today. I have the pleasure of welcoming Michael Formuziewich from our client portfolio management team. Michael (has) a wealth of knowledge as he has 20 years of industry experience across various roles in attribution analysis, investment, regulatory compliance, centralized trading, and was even a portfolio manager. Welcome to the show.
Michael: Thank you. Happy to be here.
Chiara: Markets are up. S&P five (hundred), NASDAQ, TSX all up. Double digit returns at the time of this recording. Everyone is making money, so why should investors be thinking about de-risking now?
Michael: Well, we just never know when you're going to get a large drawdown in equity performance. We could see one later this year, could be next year, could be in five years. However, behavioral studies have shown that the psychological pain of losing money is twice as powerful as the pleasure of gaining it. So a riskier portfolio, which can do very well when the market is moving up, often drawdown much more and much sharper than the market.
Michael: When markets are heading down, sell their equity portfolios and go to cash. The main risk is that upon suffering a steep decline in their portfolio value, an investor may sell their equities and go to cash. And then what often happens is that they don't step back into equity markets until markets are much higher than they were when they originally sold.
So this is sort of the sell low buy high phenomenon that we want to avoid. The above investor would probably have been better off investing in a less risky portfolio, which may not move as high when the markets were up, but then wouldn't likely decline as much when during a drawdown because that investor would be more likely to stay invested and therefore benefits when markets start moving higher again.
Chiara: It's such an a really great point there, the psychology of investing. So study after study show that fear of losing money triggers a stronger reaction than the joy of making it and often can lead to panic selling during market downturns, which we want to avoid. You know, those emotional swings and investing. So what risks should investors be aware of?
Michael: There are always risks in equity markets, but some that investors should be aware of include - first concentration risk. So much of the returns in 2023 and parts of 2024 in the U.S. And global markets have been driven by a small group of technology related companies. You might have heard of them referred to as the Magnificent Seven or “Mag seven”.
These are great companies. Think NVIDIA, Microsoft, Apple, Alphabet, Amazon, Meta and Tesla. They are extremely profitable and generate huge amounts of cash and they're very, very large. To give you an example, the size of these companies, Apple, Microsoft and NVIDIA, each individually are larger than the entire stock market in Canada. So the entire S&P TSX Composite index.
However, when you look at the last 12 to 16 months, much of their returns were due to expectations that artificial intelligence is going to benefit their future results. If the promise of AI doesn't pan out and the gains they've seen which drove market returns may reverse, we saw a bit of this over the summer when their returns trailed the market and people started calling them the lag seven.
So a second risk is economic risk. So although most economists think that Canada, U.S. and Global developed markets are going to avoid a recession caused by higher rates, it is still possible, especially if there are unforeseen economic shocks. A recession would almost certainly cause stock market to fall. A third risk is valuation risk. So valuations in the U.S. are elevated and above their ten year average.
In the last 25 years, they've only been this high twice before. In both time, there were large market drawdowns afterwards, which helped bring valuation down. And finally, there's always the risk of unforeseen events. Your so-called Black Swan, The Global Financial Crisis. An example. Before the global financial crisis, there were very few people thinking that this was going to happen.
Chiara: Yeah. So you mentioned the global financial crisis during that time, the VIX spiked and so did the beginning of August. So how did “low vol” or low volatility strategies perform relative to common equities during that pullback period in the beginning of August of this year?
Michael: Right. So the VIX measures volatility in the markets and typically the VIX spikes when markets draw down. Typically, markets draw down much more violently than they move up. So between approximately mid-July to early August, U.S, Global, and Canadian markets all fell to varying degrees to use you as an example, the S&P 500 declined 8.4% from July 16th to August 5th.
But the S&P 500, the low volatility index was down just 0.1%, outperforming by only 830 basis points or 8.3%. So quite a level of outperformance just in three weeks.
Chiara: So that really showcases, as, you know, the benefits of having a low level strategy in your portfolio, especially during periods of downturns or drawbacks. How can investors de-risk their portfolios? Can you provide our listeners some tips and tricks that they can implement in their portfolios?
Michael: Sure. So the first place to start is look at your asset mix. Equities are the riskiest asset class in terms of volatility, but they often lead to higher returns. After equities, you get fixed income, then you get cash products like money market fund, GICs or savings accounts. So increasing your exposure to fixed income and cash product will lower the overall volatility your portfolio.
However, increasing fixed income and cash in your asset mix increases your risk of not having enough saving to meet your long term retirement goal because cash and fixed income directly have lower returns in equities.
Chiara: But those investors that don't want to adjust their asset mix and are looking for ways to de-risk the equity portion of their portfolio as this normally is the riskiest portion, what can we do with an equity safety risk?
Michael: So first we can diversify our holdings. So we look at the number of holdings we look at by sector, by country and so forth. Then we can look at the type of holdings we have. So start up companies with minimal revenues or low to no profits are much more risky than large stable dividend paying companies. So to de-risk with an equity, you can focus on the larger, more stable companies.
And then third, we can look at investing in broad based ETFs. If they can help you de-risk your portfolio quickly, you get a diversified portfolio by holding sector and country assuming you buy a global or international ETF.
Chiara: I believe we have a couple of those ETFs that you mentioned. What are some ways you can de-risk with TD?
Michael: Yeah, so on or ETFs platform to do risk portfolio, we've got a few options. So we got first, our dividend ETFs, then our dedicated low volatility suite of ETFs, the TD Q Canadian Low Volatility ETF, the TD Q U.S. Low Volatility ETF, and the TD Q International Low Volatility ETF. These ETFs were designed to reduce equity volatility as much as possible.
These ETFs typically invest in very mature, very stable companies. Often those whom products or services consumers will buy no matter the state of the economy. Utilities staple products such as packaged goods, grocery stores and discount stores are some examples. These strategies often trail the market in the markets up strongly, but do very well against the market during periods of weakness.
However, I'd like to mention that these strategies weren't designed specifically to protect from market drawdowns, but it's more due to the nature of the stocks they hold. Mature cash generating dividend paying companies generally perform better when markets draw down.
Chiara: Yeah, so takeaway for our listeners. Although dividend strategies weren't designed to protect from market downturns. To be able to pay a dividend means that these companies are mature cash generating companies with sound balance sheets and therefore can perform them better during market downturns. While no one can predict while stock market valuations reach those excessively high levels or when some events might cause market sentiment to turn.
What I hope our listeners can take away that “Low Vol” strategies and dividend strategies can help provide that cushion during the sharp market downturns or those of you wanting to go a little bit more deep into the weeds in this topic, make sure to read the in-depth publication locator on her website titled De-risking Your Portfolios with Low Volatility Equities. Michael, thank you so much for joining us today.
Michael: Well, thank you very much for having me.
Chiara: And for our listeners, please don't forget to like and subscribe to the podcast.
Announcer: The information contained here is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial legal tax or investment advice. Particular investment tax or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. This material is not an offer to any person in any jurisdiction where unlawful or unauthorized.
These materials have not been reviewed by and are not registered with any securities or other regulatory authority in jurisdictions where we operate. Any general discussion or opinions contained within these materials regarding securities or market conditions represents our view or the view of the source cited. Unless otherwise indicated, such view is of the date noted and is subject to change.
Information about the portfolio holdings, asset allocation or diversification is historical and is subject to change. This document may contain forward looking statements or less FLS’s reflect current expectations and projections about future events and or outcomes based on data currently available. Such expectations and projections may be incorrect in the future, as events which were not anticipated or considered in their formulation may occur and lead to results to differ materially from those expressed or implied.
FLSs are not guarantees of future performance and reliance on affiliates should be avoided. TD Global Investment Solutions represents TD Asset Management Inc and Epoch Investment Partners Inc. Both entities are affiliates and wholly owned subsidiaries of the Toronto-dominion Bank.
Canada
