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17 oct 2019

Two defensive strategies for uncertain markets

Investors have been much more sensitive to political newsflow ever since the global financial crisis of 2007-08, and right now they have a lot to digest. Uncertainties such as Brexit and rising protectionism in the US are complex and without recent precedent, making it increasingly difficult for the market to assign probabilities to their outcome (Knightian uncertainty).

The unconventional monetary easing policies employed by central banks have, so far, helped mitigate the impact on financial markets. However, with interest rates at historic lows, central banks are low on ammunition, and political uncertainty may well have a greater impact on market performance in future (see chart).

The relationship between political uncertainty and equity volatility 

chart1

Source: Lyxor International Asset Management, Bloomberg, Davis, Steven J., 2016. “An Index of Global Economic Policy Uncertainty,” Macroeconomic Review, October. Data as at 15/10/2019. Past results are not a reliable indicator of future results.

The manufacturing slump may well worsen over the coming months, while political risk still looms with the unsolved Brexit outcome, geopolitical tensions in the Middle East and concerns over potential US trade wars.

For these reasons, we maintain a defensive bias in our equity allocation, and encourage investors to consider defensive strategies that can build portfolio resilience for the times ahead.

Diversifying safe-haven investments with Smart Beta strategies makes sense in that context. Investors have already started waking up to this. Smart Beta ETFs in Europe have recorded almost €7bn1 in net new assets (NNA) since the beginning of the year, most of the inflows went into quality, income and minimum volatility ETFs.   

Read on to learn the diversification power of two different Smart Beta strategies: Quality Income and Minimum Variance.

SG Quality Income: the safe haven diversifier

Equity income investing relies on identifying companies with sustainable dividends, particularly when the rest of the market has written them off. In this instance you can secure an income stream from the dividend and see an uptick in the share price when the market reprices the stock to reflect its true value. Of course, the risk is getting the call wrong – selecting companies with poor governance and an ultimately unsustainable dividend policy. This highlights the importance of assessing quality alongside income to ensure you own the long-term winners.  

Finding a quality investment requires searching for companies that have a good management, a strong balance sheet (low leverage & high interest cover), an enterprise life cycle, an economic moat (competitive advantage), a sound dividend policy, stable earnings and efficient operations (a good ROA).

The SG Quality Income indices provide an equally weighted portfolio of high-quality companies from either global or European equity markets. Each stock is assessed on the quality of its business using Piotroski’s F-score2, the strength of its balance sheet (Merton’s distance to default3) and targets stocks with a 4% or higher dividend yield.4 Standard size and liquidity filters are also in place.

SG Quality Income focuses on companies that pay and grow their dividend, but it also proves resilient in periods of market downturn. SG Global Quality Income (SGQI) has been on average 20%5 less volatile vs. a regular equity allocation (MSCI World NTR).

Volatility reduction vs. MSCI World index

chart2

Source: Lyxor International Asset Management, Bloomberg. Data as at 07/10/2019. Performance shown prior to 15 May 2012 is a back test. Performance does not include transaction costs. Past performance is not indicative of future performance. 3 years rolling volatility based on daily returns. Sample period starts on 01/01/2004. Data as at 08/10/2019.

Quality income investing is ultimately a contrarian strategy. While active income managers often play a role in this space, there is always a risk they stray from their remit or let emotions affect their judgement. Our index-based approach has a clear investment process, is rules-driven, and applies tighter liquidity constraints than an active manager. Going passive can add real value and security in this respect.

Minimum Variance: Build your exposure with less risk

Minimum variance strategies are based on more systematic criteria and aim to deliver reduced volatility based on historical return information. The FTSE Global Minimum Variance Index Series methodology focuses on stocks with low volatility and reduced correlation to their underlying market. By nature, these strategies tend to be less exposed to traditionally more volatile sectors such as financials, information technology and energy.6

However, the FTSE Minimum Variance methodology incorporates explicit constraints to maintain diversification and retain most of the benchmark index. This allows investors to invest almost as if they were still buying their chosen market, but with a marked reduction in volatility. This is particularly true for developed markets – as shown in the table below. 

Similar exposure with less volatility

chart 3

Source: Lyxor International Asset Management, Bloomberg, FTSE, data sample from 30/12/2006 to 30/09/2019

Seeking shelter with Lyxor ETF

While risk assets may continue to struggle in the coming weeks, protecting more of what you already have may be front of mind. Our problem-solvers help you rise to any challenge, simply and cost-effectively. Whether you’re looking for shelter against global market volatility or peace of mind in quality stocks, we offer a range of unique and ground-breaking solutions.

 1Source: Lyxor International Asset Management, Bloomberg, data as at 14/10/2019. 2 The Piotroski score is based on profitability factors such as ROA, corporate leverage and liquidity as well as operating efficiency. 3The Distance to Default (DD) is a widely used indicator of the credit quality of a company. It measures the number of standard deviations between the asset’s value and the default point. See here for SG Quality Income index detailed methodology. 4In order to meet the required minimum number of stocks, this rule may be relaxed to a dividend yield threshold of 3.5%. 5Long term average based on 3 years rolling volatility based on daily returns. Sample period starts on 01/01/2004. Data as at 08/10/2019. 6See FTSE Russell Index Methodology for Minimum Variance here

Risk Warning

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Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).

The products mentioned are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them. Updated composition of the product’s investment portfolio is available on www.lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed.

Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document is of a commercial nature and not of a regulatory nature. This material is of a commercial nature and not a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.

Research disclaimer

Lyxor International Asset Management (“LIAM”) or its employees may have or maintain business relationships with companies covered in its research reports. As a result, investors should be aware that LIAM and its employees may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see appendix at the end of this report for the analyst(s) certification(s), important disclosures and disclaimers. Alternatively, visit our global research disclosure website www.lyxoretf.com/compliance.

Conflicts of interest 

This research contains the views, opinions and recommendations of Lyxor International Asset Management (“LIAM”) Cross Asset and ETF research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental Cross Asset and ETF Research opinions and recommendations contained in Cross Asset and ETF Research sector or company research reports and from the views and opinions of other departments of LIAM and its affiliates. Lyxor Cross Asset and ETF research analysts and/or strategists routinely consult with LIAM sales and portfolio management personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of ETFs tracking equity, fixed income and commodity indices. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Lyxor has mandatory research policies and procedures that are reasonably designed to (i) ensure that purported facts in research reports are based on reliable information and (ii) to prevent improper selective or tiered dissemination of research reports. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, competitive factors and LIAM’s total revenues including revenues from management fees and investment advisory fees and distribution fees.

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