Low-volatility stocks have been all the rage recently, but is that interest justified? R. Dino Davis, investment officer and institutional portfolio manager at MFS Investment Management, thinks so. He was speaking at the 2015 Risk Management Conference held in Muskoka in August.
The challenge for pension investors is first understanding and then predicting volatility. “Predicting volatility is tough,” said Davis. “If you were investing 10 years ago, there were very different sectors that were high-vol versus low-vol within the U.S.”
Sector—and even regional—volatility rotates over time, he explained. “That’s kind of normal. We have volatility; it moves around.” When comparing the VIX to the actual 30-day annualized S&P volatility, the VIX has underestimated market shocks, he added.
Since it’s so difficult to predict volatility, investors should focus on reacting to it as it moves through sectors, regions and industries, Davis suggested.
IGH-VOL VERSUS LOW-VOL
High-volatility stocks share certain common behavioural, structural and fundamental characteristics, noted Davis.
Looking at data from the largest 1,000 stocks in the U.S. from January 1979 to December 2014, low-volatility stocks have hurt during up markets.
However, when it comes to high-vol stocks, “in the long run, they disappoint,” Dino said. “They definitely disappoint in down markets.”
Returns can also vary significantly depending on where we are in the market cycle, he added, noting higher volatility stocks approach premium levels toward the end of a bull market and then “perform abysmally as the market corrects.” In contrast, low-volatility stocks have, on average, a 4% better return on equity.
“Stocks that display higher volatility are positioned
for lower and less sustainable operating margins over time,” he added.
It’s a similar story with earnings estimates. “Higher volatility stocks are more representative of speculative growth stocks,” Dino said.
In fact, higher volatility U.S. stocks had 10% more dispersion in analysts’ forecasts. That figure jumps to 30% outside of the U.S. In other words, higher volatility stocks come with higher growth expectations, but “the consensus is not only weaker but more variable,” he explained. They also experienced more trading pressure and had higher levels of short interest.
When you consider all of these factors, “there might be a case that there’s something about high-vol that hurts,” Dino added.