Market Volatility: Insights for the ESG Investor
A Conversation Between Christopher P. Skroupa, Skytop Editor-in-Chief, and Kyle Balkissoon, Partner and Portfolio Manager, Stance Capital / January 25th, 2022
Prior to Stance Capital, LLC, Mr. Balkissoon was the Head of Cognitive Forecasting at IBM after previously serving at IBM as a Managing Strategy Consultant and Data Scientist. Prior to working at IBM Mr. Balkissoon was the Director of Quantitative Strategy at Corporate Knights Capital, and served in a previous position as a Senior Data Scientist at Capital One. Mr. Balkissoon has a MSc in Financial Markets from EDHEC Business School, a BA Honours in Economics and BSc in Mathematical Sciences from McMaster University, and holds a Series 65.
Christopher Skroupa: Now that the markets appear to be a little shaky, given concerns about inflation as one concern, how do you anticipate the S&P 500 will perform in defense of returns?
Kyle Balkissoon: Over the past 12 months, choosing to invest in an S&P 500 index fund has meant making a particularly heavy bet on the top five names in the index. Because it is a cap-weighted index, as the five trillionaire stocks have increased in value over the last several years, the influence of their performance on the overall performance of the index has grown significantly.
These stocks (GOOGL, AMZN, FB, MSFT, and APPL) currently make up around 23% of the S&P 500.
That means that 1% of the names of the index account for almost a quarter of its performance. It also means that an investor seeking diversification and protection from market volatility is highly exposed to technology, e-commerce, the cloud, and the metaverse (yes, our eyes are rolling too).
All of these themes have performed admirably in recent times, but the goal of diversification is to minimize risk concentration. An investor in the S&P 500 cannot now be considered to be diversified in our opinion.
It’s hard to think about the diversification benefits when markets have done so well for so many years, but as inflation creeps, we suspect a lot of investors will start to wonder how protected they really are.
Christopher: Indexes no longer serve as defense shields formerly offered through diversification. If this is so, how will indexes continue to meet the needs of investors?
Kyle: With indexing abdicating its diversification benefits, it opens ample opportunity to develop new approaches to creating a diversified portfolio for the twenty-first century. Cap weighted indices have served their primary purpose of offering exposure at very low costs for clients, however this methodology has also now caused heavy concentration.
We believe the future is a synthesized blend of fundamental and systematic processes. For example, we examine values and fundamentals in the first two stages of our security selection, and then our portfolios are optimized to maximize diversification and reduce correlation.
This discipline has resulted in significantly lower risk concentration compared to the S&P 500.
Furthermore, the top five names in our strategy make up only approximately 18% of the portfolio, versus the approximately 23% in the S&P 500.
Correlation should also play a key concern in the portfolio construction process. It is important to make as many independent bets as possible such that winners offset losers and skill is realized.
The correlation of the top five names in the S&P 500 is 0.71; we keep our strategy low at 0.33 because of our focus on making as many independent bets as possible.
Christopher: What is the difference between diversification and optimized diversification?
Kyle: Diversification that is making independent bets can help investors weather bear markets in large concentrated sectors. This also decreases volatility – the S&P 500 is expected to have a daily volatility of 1.57%, vs. the 1.31% expected for Stance ESG Large Cap Core Strategy.
Historically we see the effects of optimized diversification in the beta and down capture statistics for the fund. Historically Stance has had a 0.83 beta, and a down capture of 71.39%. This makes us quite defensive in general, and is largely as we are of the opinion that market risk should be traded off for specific risk such that stock selection skill can be realized.
The diversification and risk optimization has enabled us to have a lower downside deviation of 4.05%, vs. the S&P’s 4.64%.
Christopher: How do you assess the impact of ESG as an added value to the process?
Kyle: Critics sometimes argue that the addition of ESG criteria to the investment process reduces diversification and makes active risk management more difficult.
Based solely on our track record of nearly eight years, we beg to differ. With proper portfolio management, diversification, and optimization, values alignment can be free.