Natixis: Volatility & Correlations

Most investors are measuring volatility all wrong and overlooking the importance of correlations.

Reviewed by: Natixis Investment Managers
Edited by: Natixis Investment Managers

[This ETF Industry Perspective is sponsored by Natixis.]

Natixis affiliate Seeyond is the brains behind its actively managed Natixis Seeyond International Minimum Volatility ETF (MVIN), which looks to provide investors with long-term capital appreciation paired with lower volatility while investing in non-U.S. developed markets. Here, Seeyond’s Deputy CEO and CIO Nicolas Just and Head of Client Portfolio Management Alex Piré discuss the quantitative manager’s approach to markets and MVIN’s underlying thesis. Would you talk about your firm’s perspective on investing?

Just: Seeyond is an active quantitative asset manager with assets under management of $10 billion. We try to use models not to predict the direction of markets; rather, we want to use models in order to understand what kind of risks we find in the markets, what's the structure of risk in the markets, and what kind of portfolios we should build in order to incorporate, integrate or exclude risk dimensions that we want to be exposed to, or not.

What we concentrate on is using correlations in the equity markets, trying to understand where investors see risks, basically, because we think that using statistics to measure risk dimensions can give us some ideas about the protection of investors in the markets. We don’t use the classic tools that 95% of all equity portfolio managers would use, which are essentially an economic scenario including macroeconomic growth, inflation, interest rates, EPS growth and a risk measure like valuations.

We want to look at equity markets from a microstructure point of view. That means we want to analyze every stock that we look at based on their risk profile, i.e., all the correlations that any stock can have with all the other stocks within a universe.

That's a bit different from what many portfolio managers do. We don't believe we can add value estimating expected returns or EPS growth or cash flow generation. And we think so many people do it that potentially it's very difficult to generate alpha out of these predictions and this work. We tend to prefer to concentrate on the risk elements of a market. What’s going on with global markets based on that point of view?

Just: What we've been seeing over the last 20 years, in Europe as well as in the U.S., or in emerging markets, is essentially that correlations among stocks have increased quite substantially. And correlation is very important in order to understand if markets are fragile or not. High correlations are a signal to us when we look at a company or a market that there is a probability of things going wrong or going bad in the future. We tend to look at the volatility of correlations, i.e., how correlations are changing.

And what we've seen in Europe and in the U.S. over the last five years is actually, first, a trend in increasing correlations among stocks; and second, increasing volatility, an increasing trend in changes in correlations.

We think how investors look at volatility in general in the markets in order to measure the intensity of risk, this measure of volatility is no longer a good measure to understand risk—it's too low. And it's too low due to the multiyear central bank interventions around the globe, Europe, the U.S. and China.

Volatility has been depressed by all these central banks over the last five to seven years, which means that if you look at historical volatility in the market, it seems to be rather low, whereas we can see that there are a lot of risks embedded in equity markets when we look at stock signals.

We need to change the way we look at risk measures from volatility to correlations. You’ve talked about diversification and volatility. Would you discuss the relationship between those two concepts?

Just: When it comes to diversification, it's not volatility that matters that much; it’s correlations. Basically, a lot of people tend to think that in order to have a diversified portfolio, you should buy stocks from very different sectors. You would look at the sector breakdown of the MSCI indices and you would have to select stocks in every sector in order to be diversified. That was something that we've seen over the last 50 years in order to get some diversification. That's what I would call “prehistoric” diversification goals or methodologies. Because when you pick stocks in different sectors, you can still have stocks that have a very high correlation with each other, even from one sector to another. It comes down to correlations.

If you want to get a high-diversification portfolio, you need to ask yourself whenever you buy stock of a company, what is the relationship of this stock with all the other stocks that I have in my portfolio? And maybe it could be a good idea to buy the stock in terms of expected returns. But it might be a bad idea in terms of risk, because you're piling up risks from one company to another, even if they don't come from the same sector or same country.

If you use volatility and correlations and an active management overlay in order to make sure that your models—that by their nature have limits—can be used in a clever way and not blindly, then you can end up with a more diversified portfolio. But volatilities have to be used in conjunction with correlations. And as the volatility in the market is very low, the role of correlation is even more important today because the distance between high volatility stocks and low volatility stocks is very low today, even compared with what we've seen over the last 20 years. You have to use correlations much more. And that's how you get diversification.

Piré: Most investors tend to build their allocation top-down looking at sectors and countries, which are really just arbitrary buckets. We like to look at some of the holdings that we have and that we've had in the past.

One of those holdings, Partners Group,1 is something that we've held in the portfolio for a long time. And that's a company that is based in Switzerland, so it's considered a Swiss-based company and is classified as financial services.

However, Partners makes a number of infrastructure investments around the world. They invest in, amongst other things, private equity, real estate and infrastructure projects, like toll roads, airports and the like. They are much less correlated to Switzerland than they are to the rest of the world. And they're definitely not correlated to financial services. They're correlated to freight, to consumer trends, to tourism, and so forth. How would you characterize the market at the moment?

Just: We're just following a period of irrational exuberance. Q4 was irrational exuberance. There's no way markets could lose 15% in two months' time with really nothing else than worries that we're building up as a consensus.

The problem is that there is a consensus today in ideas that changes very quickly, and there's no way you can fight against it. Today it's about global recession and risks around economic wars between China and the U.S. Everybody forgot the fact that we've been worried about interest rates going up for the last three years because interest rates would have to go up. It's normal, it's written in textbooks: It would have to go up. And it went down.

I think the next cycle could be maybe in 12 months where interest rates will go up. But people are just focused on short-term worries that can disappear very quickly. Fundamentals do not play an important role today. Investors don't care about fundamentals and companies that have good products or a competitive edge. It seems to be just about risks, global macroeconomic risk factors, as well as lows.

Markets are directed by short-term perceptions and irrational exuberance. Or the new way to look at irrational exuberance is risk-on/risk-off. It's a new vocabulary, but it's exactly the same. Especially as valuations, to me, do not mean anything anymore, because there's no way you can have a great valuation today when you look at the sell-side analysts trying to value a company. The analyst would have to perform two different tasks. The first one would be to analyze the cash flow generation that a company can have in the next maybe five to ten years, which is something that analysts are good at most of the time. Then you would have to discount the cash flow generation with a discount rate that does not exist anymore.

The discount rate often used is based on the interest rate curve in the U.S. or in Europe. But there's no interest rate curve today that looks normal. It's just artificial. And I think interest rate curves have been basically kidnapped by central banks. There's no way you can ask a sell-side analyst to use a discount rate that is connected to the real interest rates that you can see on Bloomberg today. And that's a problem. Valuations do not mean much today.

Especially in Europe or in Japan, they're keeping them in negative territories. So how can you discount future cash flows with a negative interest rate? Even if you had some kind of risk premium, it doesn't mean much. It means that making a buck in three years' time is exactly the same as making a buck today, which we all know is not true. How does an ETF like MVIN capture Seeyond's outlook on volatility and correlations?

Piré: If you think about the essence of what we're trying to do at Seeyond, the portfolios that we look to build are taking a differentiated approach.

A fundamental manager will look at company fundamentals, assess valuations, assess growth prospects and build a portfolio looking at these metrics. We look at the world, as Nicolas mentioned, from a risk perspective. We seek to build a portfolio from the bottom up that looks at risk metrics—including correlation and volatility—to build a well-diversified portfolio of securities through that use of this very powerful correlation tool.

That results in a portfolio that is looking to be resilient versus the ebb and flow of the market. It's a portfolio that seeks to have a low beta, meaning a low sensitivity to the market.

MVIN is really an embodiment of how we look at the market and what we believe makes sense when investing in the market: buying those securities that are resilient, creating diversification, stepping away from those crowded trades, those high beta trades, and building a portfolio that will enable an investor to remain invested for the long term. Because that's how investors are able to build wealth for their long-term goals. Staying invested in the market is extremely important.

1 Partners Group had a weighting of 0.67% in MVIN’s portfolio as of 6/17/2019.


DEFINITIONS: Alpha is a measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk. Beta measures the volatility of a security or a portfolio in comparison to the market as a whole. Correlation is a statistical measure of how two securities move in relation to each other. Volatility is the range of variation in the value of a security due to market movements. EPS is earnings per share.

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Natixis Investment Managers includes all of the investment management and distribution entities affiliated with Natixis Distribution, L.P. and Natixis Investment Managers S.A. Natixis Advisors, L.P. is one of the independent asset managers affiliated with Natixis Investment Managers. Seeyond is operated in the U.S. through a participating affiliate arrangement with Natixis Advisors, L.P.

ALPS Distributors, Inc. is the distributor for the Natixis Seeyond International Minimum Volatility ETF. Natixis Distribution, L.P. is a marketing agent. ALPS Distributors, Inc. is not affiliated with Natixis Distribution, L.P.