First Trust urges investors to look to low vol and quality factors in down markets

Greg Guerin, First Trust

In times of market corrections, value is not the safest factor, explains Gregg Guerin (pictured), Senior Product Specialist for First Trust. 

Guerin believes that in down markets, value can be the worst returner and investors should now be looking at low volatility and quality. “In the same 25-year period, in times of market instability, quality and less volatile US equities have historically outperformed the S&P 500 Index in down months by 74 per cent and 85 per cent respectively,” he says. 

Guerin acknowledges that other factors such as value and momentum have shown historical outperformance in down markets: over the last 25 years, value and momentum outperformed in down months by only around 45 per cent and 51 per cent respectively. 

“However, at times like these, if investors want to gain market exposure but are worried about further downside in the market, quality and low volatility shoot off the page as the starting points for finding investable stocks. A combination of these two factors has a powerful smoothing effect,” he says. 

First Trust has recently launched the First Trust Value Line Dividend Index UCITS ETF, a safety ranked, high quality, low volatility, and high dividend UCITS ETF. It uses Value Line’s propriety Safety Rankings and the fund only takes stocks that have Safety Ranking of 1 or 2. It then selects those companies with a higher dividend yield than that of the S&P 500 Composite index and those that have a market cap of USD1 billion or more.

Guerin explains that it is an analyst-built model which means that companies are ranked by 60 analysts on measures such as long term debt-to-capital ratio, short term capital, return of equity over an extended time frame and even position in and cyclical nature of a company in a given industry. “These companies know how to manage their businesses which is why Value Line gave Coca-Cola a safety ranking of 1 in July 1990 and it hasn’t changed.”  

The Safety Rank measures the total risk of a stock relative to the approximately 1,700 other stocks covered in The Value Line Investment Survey. Safety Rankings are a combination of the Financial Strength rating from the analysts combined with its stock price volatility.

First Trust has also launched a capital strength model. The First Trust Capital Strength UCITS ETF focuses on high quality companies and less volatile stock prices. It selects those companies from the 500 largest companies in the US Nasdaq Benchmark index that have at least USD1 billion in cash or short-term investments, a long-term debt to market cap ratio less than 30 per cent and a return on equity greater than 15 per cent.

They are then ranked on their three and 12-month volatility, selecting 50 with the combined or lowest average score. Although it has a similar downside capture to the First Trust Value Line Dividend Index UCITS ETF, it has a higher upside capture, explains Guerin. 

“It is worth noting that the Value Line Dividend Index and both Safety Rankings 1&2 have outperformed the S&P 500 in every correction for the last decade,” says Guerin.

Guerin believes that over the next few months, investing is going to be more measured. “We will start to have more clarity in the next phase but regardless of whether an investor has an eye towards the upside or downside, quality or low volatility is a good entry point.”