Active Risk Management in a New Equity Market Cycle

by: , Director, Product Management, New York Life Investments

So far, 2017 has been a strong year for equity investors. Global equities, as measured by the MSCI World Index, returned close to 14% through the end of August. Returns have been driven by robust earnings and free cash flow growth – a trend that may continue for several years under an improving global economy with stronger corporate fundamentals.

Although the outlook for global equities remains positive, risk management will continue to play a pivotal role, particularly in a post-QE (Quantitative Easing) era. To gain better perspective, we spoke with Michael Welhoelter, CFA, Chief Risk Officer, Portfolio Manager, and Head of Quantitative Research and Risk Management at Epoch Investment Partners (“Epoch”). Epoch serves as subadvisor for multiple mutual funds offered by New York Life/MainStay Investments.

The Art of Active Risk Management

Risk management comes in various forms and is a critical component of any successful, long-term investment program. According to Michael Welhoelter, risk is defined as the probability of not achieving an expected outcome. Especially where you lack skill, you must look deeply at how you plan to manage risk.

Risk protocols command greater attention during periods of market volatility, but may be overlooked when things are going well. Policies and procedures that include ongoing risk monitoring can help maintain discipline and improve investment outcomes. Risk models are a useful tool, but are not a one-size-fits-all solution. This is where skilled risk practitioners can help fill the void and add tremendous value by carefully vetting opportunities with a team of seasoned portfolio managers and research analysts. An ongoing dialogue can more effectively balance risk and return objectives in a changing market landscape.

Building Better Portfolios

Investors may stand a better chance of navigating market volatility and achieving long-term goals by constructing durable portfolios from the perspective of “minimizing risk per unit of return”. This can be accomplished by monitoring tracking error, factor exposures, liquidity, and employing inverse risk weighting that allocates more heavily to less volatile securities. For dividend strategies, it is especially important to manage the income and free cash flow growth contribution per individual security to ensure income objectives are consistently met.

Key Components of Managing Portfolio Risk
Position Sizes Income Contribution Limit Growth Contribution Limit Inverse Risk Weightings Factor Risk Monitoring Liquidity Monitoring

Managing Risk in a Rising Rate Environment

In a rising interest-rate scenario, emphasis should be placed on the potential impact of unexpected changes in rates. Risk models and fundamental research can help identify companies with the ability to perform reasonably well under different interest-rate assumptions.

Case in point, the utilities sector includes an abundance of dividend-paying stocks, but not all companies share similar performance expectations in a rising rate environment. According to Epoch, regulated utilities have the ability to lockin higher utility pricing often over the course of several years. This adds greater comfort around a company’s ability to generate more reliable and predictable free cash flow to support dividend payments. Fundamental research can also uncover greater quality by investing in companies with dividend policies that are supported by internally generated, positive operating cash flow. At the other end of the spectrum, dividend policies that are financed by external debt add an extra layer of risk.

Identifying Quality Companies via Free Cash Flow Analysis

Epoch considers free cash flow to be a superior measure of a company’s performance. Conversely, traditional accounting metrics that focus on earnings may mask the true health of a company. Historical data suggests that free cash flow does, in fact, influence equity returns. Figure 1 shows the cumulative relative performance of each company within the MSCI World Index (by quintile) versus the overall average. Companies with higher free cash flow yields have historically outperformed those with lower free cash flow yields. In recent quarters, we have experienced a reduction in global equity correlations and rising cross-sectional volatility. This is an environment that bodes well for fundamental strategies focused on free cash flow growth.

Figure 1 – Companies with Higher FCF Yields Have Outperformed

Sources: FactSet, Epoch Investment Partners. Free cash flow (FCF) data based on the MSCI World Index (Equal-weighted), June 1996 to June 2017. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

In this chart, stocks in the investment universe (the MSCI World Index) are divided into five quintiles, grouped by stocks of companies with the highest (Quintile 1) to the lowest (Quintile 5) amounts of free cash flow yield. For the 21-year period ended June 2017, Quintile 1 returned the highest annualized excess return among the five quintiles.

Figure 2 – Performance of FCF Growth Quintiles

Annualized Return (%) Annualized Volatility (%)
Best Performing Quintile 1 10.6 17.1
Quintile 2 8.6 15.7
Quintile 3 7.3 15.8
Quintile 4 6.5 16.0
Quintile 5 3.6 18.4
All Stocks 7.2 16.5


Sources: FactSet, Epoch Investment Partners. Free cash flow (FCF) data based on the MSCI World Index (Equal-weighted), June 1996 to June 2017. Annualized total return and volatility, as measured by standard deviation. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Index performance is shown for illustrative purposes only. Indices are unmanaged, include the reinvestment of dividends and cannot be purchased directly by investors. Past performance does not guarantee future results.

The information and opinions contained herein are for general information use only as of the date appearing in this material only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

MSCI World Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity performance of 24 developed markets.

Free cash flow is the amount of cash a company is able to generate after making required investments in the existing business, such as for new machinery and to pay for supplies.

Standard deviation measures how widely dispersed a fund’s returns have been over a specific period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.

Sharpe ratio is a risk‐adjusted measure that measures reward per unit of risk. The higher the Sharpe Ratio, the better.

Actively managed strategies employ portfolio managers who decide, within the constraints of a prospectus, how assets are invested. For this service, actively managed strategies typically charge higher fees than unmanaged or passively managed strategies.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.


Kevin Kloski, CFA

Director, Product Management, New York Life Investments

Kevin recently worked as a Portfolio Specialist at Voya Investment Management, serving as a subject matter expert on fundamental and quantitative equity strategies.

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