Low-vol investing: Simple may no longer be beautiful

When low-volatility strategies were first introduced, they seemed almost too good to be true. These strategies answered a common desire of institutional investors: having the returns of the equity market but not the volatility.

At first, investors were skeptical of low-volatility strategies as they felt like alchemy: they appeared to undermine traditional investment theory, which states there can be no return without commensurate risk.

But when these strategies demonstrated they could indeed deliver equity-like returns with about two-thirds of market volatility, investors became convinced and the strategies' popularity grew.

In fact, low-volatility strategies fared better than many investors expected, exceeding equity returns while maintaining their volatility targets. In addition, these returns could be achieved cheaply by opting for passive products that replicated rules-based low-volatility indexes such as the MSCI Minimum Volatility index.

The combination of desirable risk/return characteristics along with cheap implementation made low-volatility exchange-traded funds and passive funds some of the best-selling financial products in recent years.

But they are not without risk.

Low-volatility indexes are constructed using relatively straightforward techniques. Typically, index providers simply aggregate the least volatile stocks in the cap-weighted index, while controlling for country and sector weights.

This approach might not help an investor avoid potential pitfalls, such as interest-rate risk, concentration risk or valuation risk. While these risks have created a nice tailwind in the past, it seems inevitable they will reverse at some stage.

Going forward, investors should think carefully about the approach they take to low-volatility investing.

Potential pitfall 1: interest-rate risk

Investors are increasingly aware of the interest-rate risk associated with low-volatility portfolios. Certain low-volatility stocks, which often are high dividend-paying stocks, might be seen as bond proxies in the current low-yield environment, with investors chasing yield outside fixed income.

A further increase in U.S. interest rates looks likely this year and an improving economic outlook in Europe and in the rest of the world could herald the beginning of the end of the period of ultra-loose monetary policy. In a rising rate environment, the valuation of these bond-proxy stocks might fall.

Passive low-volatility strategies take no step to avoid interest-rate risk on the portfolio. But an active manager can reduce this risk by imposing an interest-rate sensitivity constraint at a portfolio level, monitoring, for example, the -volatility portfolio's sensitivity to movements in sovereign bonds in a range of markets.

Potential pitfall 2: concentration risk

Passive strategies have a relatively constrained universe of large-cap stocks. For example, the MSCI Global Minimum Variance index only includes 300 securities. As a result, passive investors all tend to pile into the same names, causing crowding and concentration concerns.

In contrast, active managers can select stocks from a much larger universe, which creates an opportunity to further diversify their portfolio, stay away from securities that have been bid up by flows and reduce overall portfolio volatility.

Selecting stocks outside of large caps might seem counterintuitive for a low-risk portfolio. Conventional wisdom dictates that smaller stocks are more risky. While it is true that — on average — smaller stocks are riskier, there is such a large number of smaller stocks that the range of risk characteristics is very broad. Thus it is possible to select small stocks that do not behave like the average and that have, in fact, lower systematic risk.

From a correlations perspective, the heterogeneous nature of smaller stocks also makes it possible for the active manager to further increase portfolio diversity and further reduce overall portfolio volatility.

Potential pitfall 3: valuation risk

A further effect of heavy demand in a crowded universe is that individual stocks can get bid up to overrich valuations. As noted above, this might be caused by the search for yield in a low interest rate environment, or by the popularity of a particular strategy, although there could be multiple factors at work beyond that. The position is exacerbated if investors are buying on a passive basis taking no account of a stock's fundamental attractiveness. It has been argued this phenomenon occurred within the MSCI Minimum Volatility index stocks in recent years. By January 2016 the price-earnings ratio of the index stood at a 31% premium to that of the MSCI World index, the cap-weighted equivalent. During the course of 2016, particularly the second half, this situation largely reversed, leading to a relatively sharp underperformance by the Minimum Volatility index. A process that takes into account valuations might have the ability to build a portfolio less susceptible to drawdown in these periods.

Conclusion

While many investors have been able to exploit the low volatility anomaly in the past by using a relatively naive rules-based approach, this could become more challenging in the future. An active approach enables investors to invest in low-volatility portfolios, and mitigate unintentional risks, such as interest rate, concentration and valuation risks.

Olivier Systchenko is a London-based vice president at Acadian Asset Management LLC. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.