Volatility certainly meted out its fair share of punishment to investors after a decade-long bull run that saw major indexes like the S&P 500 reach historic levels. However, the growth-fueled investments provided by FAANG stocks can no longer be the go-to play for investors in the new year as a more risk-off sentiment is permeating the markets.
Even a stubborn Federal Reserve that was unwavering in its rate-hiking policy is starting to take note of the markets, especially after looking at a challenging 2018. The Dow fell 5.6 percent, while the S&P 500 lost 6.2 percent and the Nasdaq Composite fell 4 percent.
The central bank didn’t show much dynamism in 2018 with respect to monetary policy, obstinately sticking with a rate-hiking measure with four increases in the federal funds rate. That appears to have changed given the current market landscape as Fed Chair Jerome Powell is now preaching patience and adaptability.
“As always, there is no preset path for policy,” Powell said. “And particularly with muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves.”
Meanwhile, investors are moving forward and looking to defensive plays to navigate 2019 and beyond. One of the ways investors are assuming a defensive stance is through value-oriented exchange-traded funds (ETFs), and one fund that views value from a different angle is the Distillate US Fundamental Stability & Value ETF (NYSEArca: DSTL).
DSTL seeks to track the performance of the Distillate U.S. Fundamental Stability & Value Index, which was developed in 2018 by Distillate Capital Partners LLC. The index uses an objective, rules-based methodology to measure the performance of U.S.-listed, large-capitalization equity securities, selected based on certain fundamental factors.
Don’t Call it a Comeback
The common notion circulating through the capital markets is that investors have flipped on the risk-off switch to focus on value is misleading, according to Thomas Cole, CFA, CEO and Co-founder of Distillate Capital. This is especially the case since the definition of value over the years has undergone its own evolution.
“There is a string of thought that ‘value’ is due to stage a comeback, and the correction in many of the FAANG stocks will now shift investors towards ‘value,'” said Cole. “The issue with this scenario is that ‘value’ as defined by the indexes and many value oriented managers still relies on price-to-book as a definition of value.”
Metrics like the price-to-book ratio, P/E ratio and price-to-sales have been hallmarks of assessing value, but Cole begs to differ on that notion, especially given the changes in the economic climate over the years.
“Some indices and many managers also include other valuation metrics like P/E and Price-to-Sales, but because the make up of the economy has changed over the past several decades and become dominated by companies generating IP and brands, those typical accounting-based definitions of value have little to do with price-to-worth, and value as defined has become a measure of asset intensity,” Cole added.
DSTL derives its definition of value from free cash flow and ignores the metrics that are rooted in accounting fundamentals to determine a company’s price-to-worth. When measured correctly, price-to-worth can provide a truer concept of value.
“That valuation approach and our through-cycle assessment of underlying fundamental stability has shown excellent returns in the past market drawdowns,” said Cole. “Like any equity investment, some patience is necessary, but DSTL’s design inherently takes advantage of periods of market volatility and drawdowns when conventional measures of risk lead investors away from taking smart risks, and we are drawn toward them.”
Low Volatility Doesn’t Translate to Low Risk
Another common misnomer in the capital markets is that low volatility translates to lower risk. According to Investopedia, volatility is defined as “a statistical measure of the dispersion of returns for a given security or market index.”
Therein lies the issue as the definition makes no mention of risk. To Cole, this is exactly where investors can fall into the trap of assuming that low volatility will equate to automatic downside protection.
“Stock price volatility is an often-used proxy to assess risk, but as Warren Buffet wrote in his 2014 letter to Berkshire shareholders, while the metric is universally used and taught, ‘… it is dead wrong. Volatility is far from synonymous with risk,'” said Cole. ” Many investors are buying low volatility presuming it translates to low risk or downside protection or in an attempt to take advantage of the ‘low beta anomaly’. They are likely to be disappointed.”
According to Cole, there are a number of moving parts to explain why price volatility doesn’t necessarily translate to risk. However, the important takeaway is that investors may be paying too much by purchasing products that purportedly have a low-volatility component built in to the strategy.
“The price paid for any asset is critical to the ultimate return,” said Cole. “The flows into low volatility ETF’s have driven the prices of stocks exhibiting low share price volatility higher, ignoring the risk that a high price in itself is a considerable risk. In the past, whether on a large or smaller scale, when the market becomes driven by factors that ignore price-paid, the results are typically quite poor and sometimes disastrous.”
Blunting the Swings of Volatility
Investors looking to DSTL as an option to mute or blunt the impact of volatility can examine its core strategy–one that looks at value through a different lens and screens for high value investments that will not only provide the best returns over time, but also minimize the impact of volatility should the heavy price oscillations of the market make more appearances in 2019.
“DSTL utilizes an assessment of company-level fundamental stability and balance sheet quality to better assess the risk of potential holdings,” said Cole. “We then systematically rebalance the portfolio into the stocks that rank the best on our measure of the valuation opportunities available in the market. The result is a very high quality portfolio of stocks that exhibit strong through-cycle stability, but also utilize valuation as a measure of downside protection.”
For more information on Distillate Capital, click here.
For more information on DSTL, click here.
For more market trends, visit ETF Trends.