To get more return, you have to take on more risk, right? That’s modern portfolio theory, proposed by Harry Markowitz in his 1952 paper, “Portfolio Selection.”
Intuitively, this makes perfect sense. But other academic research (e.g., “The Volatility Effect: Lower Risk Without Lower Return” by David C. Blitz and Pim van Vliet, April 2007) has shown that, over a long period of time, investors can get higher returns for less volatility—known as the low-volatility anomaly.
For example, academic research shows that “if you compartmentalize stocks by their volatility and take the lowest quintile of volatile stocks over time, they will outperform the quintile of the highest volatile stocks,” says Zainul Ali, head of North American manager research with Towers Watson.
Coming out of the 2008 financial crisis, there has been growing interest in low-vol strategies. However, “the reason low-volatility equities have delivered better risk-adjusted returns is because everybody else blindly invests in the cap-weighted traditional indexes, basically,” says Jean Masson, managing director with TD Asset Management (TDAM).
The Lowdown on Low Vol
A low-volatility equity strategy tries to exploit one systematic factor: price volatility. “The idea is to build a portfolio with the lowest volatile stocks. If you do that, over a long period of time, you should be able to get at least market-type returns,” says Ali.
Masson says these stocks are the ones that investors don’t much pay attention to: the “unloved stocks.” “Stocks that you know exist but are rarely on the front cover of newspapers.” Traditionally, they’ve been in the areas of consumer staples, healthcare and utilities. However, this is not always the case. “Lowvolatility portfolios really are trying to capture this anomaly, and that anomaly can exist within other sectors as well,” says Ross Dowd, executive vice-president and head of global marketing with Acadian Asset Management.
Of course, no two investment products are alike. There are a few different ways to come at a low-vol fund. First, there’s choosing the lowest volatile stocks over a specified period, says Ali. Some managers then go a step further by imposing constraints on sector and single stock weights. Others go even further by using stock correlations to optimize the portfolio to get the best risk/return profile. “They look to see how [the stocks are] correlated with others in the portfolio, and maybe they can kick out a few in the first two iterations,” he explains.
Some managers—TDAM, for one—hold stocks in their low-vol portfolios that are not, individually, considered low volatility. “We hold a few gold mines,” Masson says. “If you were to analyze these gold mines on their own, they’re pretty volatile stocks. But they perform well in some economic situations when most consumer staples, telecoms and utilities may perform badly.” He adds that TDAM’s portfolio is expected to be less volatile with 2% in gold stocks than with 0% in gold stocks.
Pros and Cons
Low-volatility strategies are appealing to pension plans, since many are trying to de-risk. If plans can get at least markettype returns for less risk, why wouldn’t they do it?
Jeff Tiefenbach, senior vice-president, international equities, with Greystone Managed Investments, says one advantage of low-vol funds is that they allow investors to stay in the markets, where they might otherwise have exited them early or moved more into fixed income.
“If you switch into fixed income, you’re going to lower the return profile of your fund,” says Tiefenbach. “Investors, as an alternative, can lower risk by going into a lower-volatility equity strategy, which can reduce the risk of their fund without dramatically changing the return profile.”
One issue, however, is benchmarking. The returns of lower-volatility strategies tend not to look like the benchmarks, Tiefenbach explains. Masson agrees. “If you need to compare returns on your equity portfolio to those of an index that everybody chooses as a benchmark, then you might lose sleep if you invest in a strategy that’s very, very different. Lowvolatility equities would be one of those.”
Pension plan sponsors may also find it difficult to understand how their plan’s performance compares to those of their peers. “[Institutional investors] will compare OMERS with Teachers’ and CPPIB, for example,” says Masson. “I think they should really focus on whether these institutional pension plans are succeeding in meeting their obligations, because that’s really the endgame. Can they deliver on the pension promise? If they can, that’s what matters.”
Another potential issue is underperformance in a strong market. “In a strong up market, the market tends to reward more volatile companies—ones that have more financial leverage,” adds Tiefenbach.
When Low Vol Is Not Low Vol
With all of the current product hype, will investors know a real low-vol strategy when they see one? “True low-volatility products are specifically designed to target low volatility,” says David Zanutto, a partner with Mercer. “That’s very apparent. There’s no disguising going on there.”
However, Zanutto admits that a few managers he’s seen have relabelled or rebranded their existing products. For example, a manager may have a product that targets high dividend yield, which is legitimate on its own, says Zanutto. “We’ve seen a few of those managers say, ‘This fits with what I hear to be low vol.’ They either relabel it or create marketing materials about it being a low-volatility product. Through the relabelling or marketing, [some managers] are trying to ride the wave of investors looking for low volatility.”
Investors can discern the nature of a product, regardless of the label, by asking managers how they’re designing the product and the kinds of stocks they’re looking at, Zanutto adds.
Tiefenbach also notes that there is potential risk relating to valuations for low-vol stocks. “We are seeing more investor interest in flow into lowervolatility strategies,” he says. “You have to be careful that these stocks that exhibit lower-volatility characteristics do not get overpriced in the market—then you’ll be paying too much for them.”
Also, management fees should be lower for low-vol strategies, explains Ali—somewhere between what you’d pay for indexed funds and an active manager’s equity strategy. Investors, he says, should not pay active management fees for smart beta strategies, including low-vol funds, because the strategies don’t require it. “Extracting volatility, in our minds, is not a specialized skill set.”
The Next Iteration
Low-vol strategies have done well over the last number of years. For instance, TDAM’s Emerald Low Volatility Canadian Equity Pooled Fund Trust (PFT) has beat its benchmark by almost 10 percentage points since its inception in 2009. Similarly, its Emerald Low Volatility Global Equity PFT has beat its benchmark by about three percentage points since its inception the same year. “Basically, these strategies have had the wind at their backs,” says Ali.
However, Ali doesn’t think low vol is the next best thing. “It’s simply another arrow in a manager’s quiver,” he says, adding that there are always new strategies being developed. It’s no different from, say, a value-based strategy, he continues—it will have its peaks and troughs. “The whole idea of a low-vol strategy either providing market returns or beating markets is based on long periods of time; it’s not based on a oneor three-year period, or even a five-year period,” he adds.
Down the road, Zanutto thinks there may be better prospects for low-vol strategies that incorporate explicit return forecasts. “Building a strategy to achieve low vol to the exclusion of return forecasts could lead to lower returns— especially if these types of low-vol stocks get further bought because of more interest in the strategy,” he explains. “A more successful implementation going forward is likely one where a manager will take account of return prospects along with building the portfolio to achieve low volatility.”
Brooke Smith is managing editor of Benefits Canada.
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