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Factor investing: The paradox of low volatility

Despite scepticism by some investors, low-volatility investing does appear to work, especially during market downturns 

Key Points

  • Low-volatility investing seems to run counter to narrow ideas of economic rationality
  • The empirical evidence suggests low-volatility investing does work
  • MSCI’s low-vol indices are among the most popular
  • Some remain sceptical of the low-vol approach

Economics is not an experimental science despite appearing to have a strong case of physics envy when it comes to developing theoretical frameworks to explain the real world. Investment behaviour sometimes seems to run counter to what might be expected from a narrow view of economic rationality.

Take two models that are central to the whole edifice of financial economics. Modern portfolio theory (MPT) was constructed around Nobel prize winner Harry Markowitz’s approach to creating efficient portfolios based on the assumption that investors would demand greater returns for assets with greater risks. That, in turn, led to the capital asset pricing model (CAPM), and the associated idea that investors could obtain portfolios at any risk level desired, by taking the market portfolio and either leveraging it or combining it with cash in each case, paying or receiving interest at the risk-free rate. 

These constructs are rooted in particular assumptions about human behaviour, albeit that of crowds rather than individuals. In its strongest form, such reasoning assumes rationality, unencumbered self-interest and the idea that human beings strive to maximise well-defined utility functions to achieve happiness. 

Yet such models often seem to be at odds with real-world investment behaviour. For example, the existence of sustained risk-adjusted outperformance through investing in low-volatility assets appears contradictory from the perspective of pure economic rationality. From a narrow economic perspective it does not make sense that investors can be rewarded with higher risk-adjusted returns for investing in less-volatile portfolios. 

The empirical evidence suggests that low-volatility investing does, indeed, work, says Mehdi Alighanbari, factor strategist at MSCI. Not only for equities but also for other asset classes including US Treasury bonds, corporate bonds and foreign exchange. There are some good real-world reasons why this should be the case. 

jan sytze mosselaar

Jan Sytze Mosselaar, quantitative portfolio equity manager at Robeco, points out that benchmark-evaluated fund managers focused on delivering outperformance and minimising relative risk overlook low-risk stocks. They may even be willing to take unrewarded risks, as in a lottery, to become a winner, since the upside by doing so is high, while the downside is limited. 

Constraints on borrowing also prevent investors from leveraging up market portfolios to efficiently achieve greater returns as theory recommends so, instead, they overweight high-beta stocks. Such factors will persist and as a result there appears to be a systematic and structural outperformance of low-volatility assets. 

A characteristic of low-volatility approaches, as they tend to be focused on defensive stocks, is that they do better during downturns. Firms running low-volatility strategies typically seek to achieve a lower risk than the market – some 25% in Robeco’s case, over a full performance cycle. 

Incorporating historical correlations between stocks to calculate contribution to portfolio risk for a stock can also be tricky, as such correlations tend to be unstable, leading to high turnover. “We don’t rely on correlations but use equal weighting in assessing risk contributions and so have a low turnover of around 25% a year,” says Robeco’s Mosselaar. 

By contrast, DWS does take account of correlations which, argues Irina Sidorovitch, head of equity quantitative portfolio management, means smaller companies can add significant value in terms of diversification and risk reduction. In combination with its stock selection model, this might result in turnover of closer to an annual rate of 60%.

While low-volatility strategies will lag market returns during bull markets, the idea is that their outperformance during bear markets more than compensates. This can be seen even in passive products such as MSCI’s minimum volatility index, one of its most popular smart beta indices. This has been running for over a decade and available to investors through smart-beta strategies. For the 10 years of live data to 2018, the annual outperformance was 1.3%. 

Low-volatility approaches, not surprisingly, perform best during periods of high volatility and most of the outperformance of the MSCI index can be attributed to the more turbulent market of the first five years (2008-13). More recently, during the low-volatility up-trending market of the past five years, the return has been in line with the parent index, although with lower volatility and a superior risk-adjusted performance.

msci world versus volatility

The low-volatility effect has been sensitive to changing market conditions. When interest rates were going down, minimum volatility strategies tended to outperform and, conversely, strategies underperform during periods of rising rates, according to Alighanbari. “The 2018 environment was of rising rates and expectations that rates would continue rising in a turbulent market. That meant two factors impact low-volatility effect in opposite directions but the impact of turbulence was much stronger, leading to outperformance,” he says.  In the second quarter of 2018, low volatility really showed its strength as, while the MSCI broad market index fell 12%, the low volatility index fell only 5.5%.

“You can’t compare high-beta small-cap with high-beta large-cap as there is no correlation between different asset classes and they behave differently” - Harin de Silva

Does the low-volatility anomaly depend on the universe being considered? Yes, says Harin de Silva, a portfolio manager at Analytic Investors, which has $10bn (€9bn) AUM in explicit low-volatility strategies. De Silva sees three distinct equity markets whose constituents should not be mixed within low-volatility strategies, namely developed market large-cap stocks, developed market mid-cap stocks and emerging markets. “High beta small-cap will underperform a low-beta small-cap, but you can’t compare high-beta small-cap with high-beta large-cap as there is no correlation between different asset classes and they behave differently.” 

irina sidorovitch

There are also structural differences between developed and emerging markets, Sidorovitch points out. “In emerging markets, country and regional exposures are more important than sectors for individual companies, and the opposite is true for developed.” 

Robeco, however, does combine emerging markets with global developed in some portfolios. Mosselaar says: “A lot of emerging market companies can be less volatile than developed. We prefer Malaysian banks, for example, which are more stable than European banks.” 

Not all quant managers are fans of low-volatility investing, though. While low-volatility investing may give higher risk-adjusted returns when looked at in isolation, QMA does not include the factor within its multi-strategy equity portfolios. Andrew Dyson, CEO of QMA, says this is because it does not see it as offering sustainably higher returns than the market. It typically

includes 13 or 14 independent signals within its multi-strategy equity portfolios, each of which has an expected outperformance, so it can achieve diversification and high risk-adjusted returns without resorting to factors which, while reducing risk, do not add significant return, says Dyson.

Given the underlying behavourial explanations for the low-volatility anomaly, it is not surprising that managers are seeking it in other markets. The most successful appears to be in the corporate credit markets. Robeco, for example, has taken the research on equity markets straight over to credit markets and also undertaken research on credit commodity markets where it has found evidence of commodities with lower volatility outperforming high volatility commodities. 

MSCI has undertaken research in foreign exchange (FX) markets and also uses an adaptive FX hedging strategy for its equity indices, says Alighanbari, exploiting the fact that emerging market currencies have higher volatilities than the dollar, euro and sterling. The low-volatility anomaly can even be exploited in long/short approaches. 

De Silva’s team runs long/short strategies of interest to investors looking for absolute-return oriented approaches where it is long 100 stocks with a beta of 0.9, or so, and short 30 high-beta stocks which, he says, does well in down markets. Perhaps active managers should be grateful that economics is not entirely scientific.

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