Stephen Miles looks at the pitfalls between a smart idea and its smart execution
Low-volatility equity strategies have gained a lot of attention in the last two years, with proponents claiming that they can deliver market level returns for below market level risk. The observed ‘low-volatility effect’ is global, we have seen significant interest from our clients worldwide and the volume of new product launches from asset managers has been remarkable.
Towers Watson’s Thinking Ahead team was one of the first groups to advocate the use of inexpensive, transparent, systematic strategies (‘smart beta’) as an attractive alternative to both market cap-weighted indices and some forms of traditional active management. Our institutional investment clients have allocated over £10bn (€12.4bn) to smart beta solutions in the past five years. In addition, our active equity manager research team has, for many years, been a proponent of skilled managers with defensive, quality-oriented approaches, particularly during periods of high market uncertainty. Combining the broad smart beta initiative and defensive equity investing brings us to smart beta low-volatility equity strategies.
The potential merits of the low-volatility thesis are quite compelling: it is supported by long-term empirical evidence with plausible intuitive rationales; there is the prospect of reduced volatility, reduced absolute drawdowns and improved reward per unit of risk; it has the potential for use in de-risking programmes; and, finally, low-volatility strategies can be inexpensive, transparent and widely available.
While the low-volatility concept is worth investigating, there are potential hazards along the path from the initial idea to final implementation. There is a very wide range of strategies to consider and smart beta investments are a new avenue for many investors. Furthermore, the effect of recent impressive results from the strategy tends to raise expectations rather than caution – which may be a more appropriate reaction. We believe it is essential to carefully navigate some of the potential pitfalls, which we highlight here.
Based on empirical evidence and intuitive supporting arguments (such as investor preference for lottery-type payoffs and limits to arbitrage from leverage constraints) we believe that while there is a trade-off between return and risk, this relationship may be flatter than traditional market theory suggests over the long term. If so, a low-volatility equity portfolio may have a higher risk-adjusted return than the market as the reduction in risk is achieved with only a moderate sacrifice of return. But it is important to note that we expect a somewhat lower than market return from (unlevered, long-only) low-volatility equity strategies over the long term. We would argue that having a central expectation that these strategies will provide significant risk reduction without any sacrifice of long-term return is counter-intuitive and overemphasises results from period-specific historical backtests. Hence, we are cautious of the common statement used in marketing presentations: ‘Market level returns for below market level risk’.
It is important for investors to determine, in advance, their objectives from an investment in a low-volatility equity strategy. Different approaches to measurement may determine whether such an investment is considered a success or a failure.
The case we most typically hear supporting low-volatility equity is a strategic one based on long-term historical evidence. However, we believe that markets are complex adaptive systems – meaning that long-term past factor performance should only be a tentative guide to the future. As demand for low-volatility equity strategies increases then a portfolio of low-volatility stocks becomes more expensive, thus reducing future returns, all else being equal. Our analysis of current market conditions considers the valuation of a global low-volatility strategy from several angles. Recently we have observed that, while the strategy looks reasonable from an absolute valuation perspective, the relative valuation appears stretched compared to historical levels.
Selecting the right product
Perhaps the greatest challenge to an investor looking to invest in a low-volatility strategy is the overwhelming choice available.
We believe there is a ‘devil in the detail’ challenge when evaluating low-volatility equity strategies. One key differentiating factor is the breadth of methodology. We are cautious of processes that solely emphasise low historical price volatility to select securities. In some global equity simulations of this approach we observed a large allocation to the financial sector prior to the global financial crisis. This would probably surprise investors thinking they were buying a ‘safer’ portfolio of equities.
This example demonstrates that low historical stock price volatility is not a watertight guide to the future resilience of a business. The criterion for a stock to have low historical price volatility is simply that there were few sudden changes in the balance between buyers and sellers over the particular period in question. We are also concerned that undifferentiated low-volatility strategies may suffer from poor liquidity owing to the crowding of similar approaches buying the same universe of stocks (as experienced by quantitatively driven approaches in 2007).
Products in this space differ considerably in terms of their complexity. Examples include embedded quantitative alpha models, fundamental risk models, statistically based principal component models, implied volatility models and various optimisation techniques. The more complex the process the less transparent and the more effort is required to evaluate the relative expertise of the manager. The existence of more moving parts within a process often leads to higher turnover and potentially higher transaction costs. Furthermore, greater complexity usually results in greater management fees. We would argue that fees in this area should be low given the moderate running costs, high capacity, and the intense level of market competition.
In summary, we are strong advocates of smart beta investments as a new avenue for many investors, as witnessed by our leading efforts in this area. In our view, low-volatility equity can indeed be smart, but only by avoiding the potential pitfalls. Whether it is setting the right expectations, considering market conditions or choosing the right product, a pressing onus rests with investors and their advisers to bridge the gap.
Stephen Miles is a senior investment consultant at Towers Watson