Low-volatility equity strategies have emerged as a viable option for investors seeking risk-managed growth. Interest in de-risking equity portfolios continues to grow given increased volatility and emphasis on loss limitation. Much of this interest can be attributed to factors that may persist, such as global growth concerns, negative real interest rates, global currency volatility and lack of stability in the commodity complex. With that in mind, we asked Westwood Management’s Global Convertibles Portfolio Managers, David Clott and Shawn Mato, to share their insights on the role global convertibles can play as a low-volatility strategy within a portfolio.
What makes global convertible securities an attractive low-volatility investment?
David: Convertible securities are hybrid, equity-linked securities that can offer investors many advantages, particularly in a low rate environment with persistent market volatility. Convertible securities exhibit a lower volatility profile due to their diversified sources of return. Investors in convertible securities benefit from bond-like features, such as current income and a principal repayment on maturity, along with an additional equity conversion option in the future. Therefore, investors can participate when the equity market rises, but with limited downside due to the bond-like features, which are a potential buffer during periods of declining equity markets.
What are the long-term advantages of global convertibles compared to traditional global equity?
Shawn: The characteristics mentioned by David can potentially provide investors a structural asymmetric advantage over the long term with equity-like returns yet with two-thirds equity risk. For the 10-year period ending March 31, 2016, the Thomson Reuters Global Focus Convertible Bond Index provided competitive returns, up 3.86% annually versus 4.27% for the MSCI World-ND Index. More importantly, the emphasis on lower volatility and higher risk-adjusted returns is highlighted by the 10-year comparison as measured by annualized performance, volatility (indicated through standard deviation) and portfolio efficiency (indicated through Sharpe Ratio).
David: In this chart, you can see the asymmetric advantage of global convertibles to provide downside protection. On average during the last four market downturns, the Thomson Reuters Global Focus Convertible Bond Index provided a downside capture rate of only 58% versus global equity markets, as defined by the MSCI World-ND Index.
Shawn: More recently, 2015 highlighted the potential risk-adjusted return benefits of global convertibles as an asset class and why it has a place in the asset allocation decision process. The global market performed admirably in a volatile 2015 relative to global core equity and bond asset classes. In 2015, the Thomson Reuters Global Focus Convertible Bond Index outperformed the Barclays Global Credit Index by 322 basis points (bps) and outperformed the MSCI World-ND Index by 70 bps.
Are global convertibles attractively valued in today’s market environment?
David: Global convertible valuations are the most attractive since the global financial crisis in 2008. We continue to see the asset class exhibit a level of equity sensitivity as the market recovers while providing downside support if the market backtracks from recent highs. The convertible market continues to remain a robust funding avenue for global corporations. From 2013 to 2015, gross new issuance averaged nearly $88 billion per annum, and we expect a similar result for issuance in 2016 as companies look to raise capital to support M&A activity, refinance debt and improve their balance sheet.
Why do you believe that active management is required in this asset class?
Shawn: As a result of the overall market dynamics, convertible securities are an asset class that introduces structural complexity due to a wide range of characteristics. In our view, passive solutions like ETFs lack the ability to maximize the structural benefits of the asset class and can present potential liquidity challenges. Several variations exist within the convertibles universe that dynamically change depending on market fluctuations including equity, credit spread, interest rate and volatility sensitivity as well as pricing inefficiencies. Because of these aforementioned complexities, we believe that active management utilizing a global universe with an unconstrained approach is optimal to maximizing the asymmetric advantage of the asset class.
At Westwood Trust, we believe global convertibles are a viable option as a low-volatility equity allocation for investors seeking risk-managed growth and downside protection. If this is a strategy that you would like to explore, we would be happy to discuss whether or not it makes sense for your personal financial situation. Thank you for the continued trust you place in Westwood Trust.