Non-Cyclical, High-Yielding Equities are Part of the Duration Bubble

With interest rates close to zero and no sign of central banks ending loose monetary policies, naturally risk-averse investors are being pushed out of bonds into equities because they offer one of few ways to generate a meaningful return on capital or income yield.

Companies that pay a sustainable dividend and do not have a high degree of economic cyclicality are proving one of the “go-to” investment themes. While such companies, typically in sectors such as consumer staples, telecoms and utilities, have obvious attractions as bond proxies, they will be vulnerable to changes in the interest rate environment and therefore pose potentially significant risks.

Minimum volatility (Min Vol) ETFs, particularly in the US, have also proved popular and are at the forefront of the growth of smart beta ETFs. They track Min Vol indices, which are constructed to invest in equities that have much lower volatility characteristics than the underlying market index. These indices have a much higher weight in defensive sectors and less cyclical exposure than the broader market.

One factor that is potentially overlooked and yet important to consider in analysing such indices is the price being paid for the “safety” of low volatility. For example, the S&P 500 trades at a price/book ratio of 2.8 and an average price/earnings of 24.6, while the consumer staple and utility heavy MSCI USA Minimum Volatility index trades at 3.33x book value and 26.1x average earnings. The companies that make up the Min Vol indices have been historically less volatile, but given the appetite for these types have stock they now come with much higher valuation risk than their history might suggest.

We are concerned that the first hint of a downturn in performance from these strategies will see a disproportionate sell-off because many of the investors allocating to this strategy are not natural equity investors. As they move back the safety of cash, they risk magnifying the volatility that they are trying to avoid. Given the strong performance of these equities in these “defensive” sectors, it would make sense to cut exposure well in advance of a rise in interest rates.

Patrick Armstrong, chief investment officer at Plurimi Investment Managers LLP (PIM).

PIM is an award-winning global macro and multi-asset specialist firm. The firm has a distinguished track record which offers alternative solutions with liquidity, transparency and consistent real returns. PIM, using proprietary risk and portfolio management systems, applies long-term macroeconomic trends with systematic forecasting of medium-term market dislocations across global markets. PIM is part of the Plurimi Group (GBP 1.7 billion AuM).