In this question and answer format, Eugene and Ryan discuss the outlook for low-volatility equities and why, with a lower risk profile than traditional equities, they remain a strategic component in a well-diversified portfolio despite current valuation concerns.

Q: Recently the financial press has been publishing articles discussing the elevated valuations of low-volatility equities. Does that mean that you are considering selling?

A: Eugene: We believe the primary reason to invest in a low-volatility equity strategy is the risk reduction characteristics of the strategy. The current valuation picture does not change the expectation that managed-volatility equity strategies are expected to hold up better, mitigating losses, in the event of a down-market. Because of this, we are not selling allocations to low-volatility equities, even though we share the consensus view that low-volatility equities appear to have elevated valuations.

Ryan: SEI believes that from a long-term, strategic perspective, establishing the appropriate policy portfolio sets the foundation for achieving investors’ goals and objectives. We also believe there are shorter-term opportunities to improve risk-adjusted returns, but it’s important to clearly distinguish between these two perspectives. The valuation of lower-volatility equities may present a shorter-term opportunity for Eugene to position his funds accordingly, but unless something has structurally changed with respect to the efficacy of managed-volatility equity strategies, this has no bearing on its role in the strategic asset allocation. And, to be clear, nothing has structurally changed – the risk reduction benefits and the reasons for strategically allocating to managed-volatility are still intact. We are maintaining our strategic allocations to managed-volatility equity.

Total Portfolio Discussion

Q: Ryan, do current valuations change the way you think about the role of managed volatility equity in investors’ portfolios?

A: No. Strategic allocations to managed-volatility equity remain appropriate for investors with a focus on drawdown risk. Managed-volatility equity is primarily found in more conservative portfolios and allows investors to access equity markets with the expectation of lower risk than traditional, market capitalization weighted strategies. From a total portfolio perspective, a managed-volatility strategy plays an important role: providing an opportunity for equity-like growth, while mitigating the associated downside risks. Above-average valuations may contribute to underperformance versus traditional equity strategies, but SEI’s managed-volatility funds remain well-positioned to deliver a risk reduction benefit, fulfilling their strategic role within the total portfolio.

Q: Ryan, how do Eugene’s views factor into your active asset allocation decisions in strategies?

A: The Portfolio Strategies Group (PSG) has been actively engaged in conversations with Eugene regarding the valuation of lower-volatility equities, and it continues to be a theme that we’re watching closely. While lower-volatility equities appear expensive compared to higher-volatility equities, PSG is maintaining a neutral position. Bottom-up positioning within SEI’s equity strategies, including managed volatility, is appropriately reflective of the valuation disparity, which does not currently warrant a top-down, active underweight, in PSG’s view.

Question: Eugene, since the end of the global financial crisis low-volatility or managed-volatility equity strategies have performed well compared to strategies that don’t focus primarily on managing volatility. Can you elaborate on that?

Answer: Overall, the environment has been pretty favorable for equities. Central banks have kept policy rates low and used a variety of quantitative easing measures to drive bond yields down; even producing negative yields in some countries including Germany and Japan. Stimulative monetary policy is typically positive for stocks. In addition, the low bond yields combined with investor demand for yield was positive for the steady dividend payers in the defensive sectors. This has resulted in a tremendous amount of momentum in defensive sectors, and of course, those defensive sectors tend to be the foundation for any equity strategy that attempts to manage volatility. We’ve also had some pretty significant bouts of volatility, which is usually good for relative performance. The corrections in 2010 and 2011 were more of the garden variety bull market corrections. Meanwhile, the corrections in 2015 and to start 2016 were more based on legitimate concerns about Chinese growth and slumping commodity prices. But in any case, corrections of any sort are often positive for the relative performance of low-volatility strategies.

Q: Eugene, if low-volatility equities appear elevated- what are you doing to exploit that? How are you positioned?

A: Within dedicated Managed Volatility Funds, we have to attempt to deliver the primary investment objective of risk reduction; therefore, buying a value manager full of energy and material stocks is out of the question. However, we can still allocate more to the managers that are more valuation aware and away from the momentum-based trend followers. This is what we believe is an advantage of our active strategy over a passive one; we can adjust allocations in an effort to profit from opportunities we see in the market.

Q: Eugene, what is your outlook for low-volatility equities?

A: We don’t foresee the same performance advantage that we have seen over the past ten years or so, this is especially true if markets continue trending upwards. But we still expect our managed-volatility equity strategies to offer higher risk-adjusted returns. We see two likely potential outcomes here. The less probable outcome, in our view, would involve a sharp acceleration in global economic growth and higher interest rates leading to less risk aversion and fuelling a strong equity market rally that is accompanied by a bond sell off. In this situation, higher-volatility equities would generally be expected to outperform lower-volatility equities. We believe it is more likely that the broad equity market will continue to grind slowly higher as it is held back by full valuations; low-volatility equities would likely have a tougher time keeping pace with higher-volatility equities if/when interest rates normalize (i.e. gradually rise). Longer-term, we still believe the strategy could produce market-like returns despite the short-term concerns. In both cases, investors need to factor in the lower risk nature of a managed volatility strategy in addition to the return experience.

Q: Eugene, what do you see as the biggest risks?

A: There are always the standard risks associated with equity investing, but beyond that, we view a global recession as the top equity risk right now. We don’t believe a recession is imminent though, and this is reflected in the fund positioning I mentioned earlier. Further, while a recession would likely hinder absolute performance, importantly, we’d expect low-volatility equities to outperform on a relative basis. We also noted our valuation concerns earlier; there certainly is the possibility of a pullback in defensive sectors given their elevated valuations relative to other sectors.

Q: Earlier, you mentioned that low-volatility equities had a “tremendous amount of momentum”. Is it rare for momentum to be concentrated in the more defensive sectors of the equity market?

A: Not necessarily. Many investors associate momentum with growth-oriented sectors, but there are different types of momentum. We’ve seen more price momentum in defensive sectors recently. What is a little unusual is that defensive sectors have, at times, led equity markets higher during the current bull market.

Q: Eugene, can you discuss strategies for currency hedging in your global managed-volatility funds?

A: Hedging is primarily a function of which currency the fund is denominated in and where investors are domiciled. The U.S. dollar is considered the world’s reserve currency, so it makes sense for investors of most domiciles to hold some exposure to it. Conversely, principles of diversification apply to currencies too. For example, a weak dollar is likely to increase import prices and inflation in the U.S., weighing negatively on dollar-denominated assets, but at the same time creating positive dynamics for many foreign currencies. For funds that employ strategic currency hedging, we make the trade-off of statistical precision versus common sense prudence and strategically hedge 50% of the foreign currency exposure back to the U.S. dollar. This helps reduce the risk that a strong dollar will hinder performance. Keep in mind this is a strategic position, so we can always deviate from this if we have a strong currency view. At one point, we had U.S. dollar funds fully hedged; this was quite positive as the U.S. dollar strengthened from 2014 to 2015.

Important Information
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. Diversification may not protect against market risk. There is no assurance the goals of the strategies discussed will be met.
SEI Investments Management Corporation (SIMC) is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCo). SIMC and SIDCo are wholly owned subsidiaries of SEI Investments Company (SEI). Neither SEI nor its subsidiaries is affiliated with your financial advisor.
For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement.
To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing.