Why are low-risk equity strategies so popular with institutional investors these days? “It’s an acknowledgment that market timing is very, very hard,” explained Brendan O. Bradley, director of portfolio management with Acadian Asset Management. He was speaking at the 2014 Risk Management Conference in Muskoka, Ontario, which was held August 13-15.
“Realistically, low-risk stocks perform better than they’re supposed to and high-risk stocks perform worse,” he said, citing 1992 data from Fama & French.
The benefits of low-risk equity strategies include the same average returns, lower volatility, lower drawdowns and better compounding, Bradley explained. “One of the real benefits of these strategies is compounding…it’s the only free lunch of these strategies.”
However, there are hidden risks. Here are the main risks of low-risk equity strategies and how to mitigate them.
1. Valuation risk
When it comes to valuations, “you’ve got nothing in your decision-making process that prevents you from buying expensive stocks,” said Bradley—but it doesn’t have to be that way.
The range of valuations within the universe of low-risk stocks is wider than it’s ever been, he explained. “If you’re trying to build a low-risk portfolio, it’s really up to you…you can have something that’s a little bit cheaper than the market or something that’s a little bit more expensive.”
2. Interest rate risk
Low-risk stocks “live somewhere between stocks and bonds,” said Bradley. But since they co-move with bonds, they do have some interest rate sensitivity.
However, “you can build basically the same portfolio but with the interest rate sensitivity built into it,” he explained, noting that the risk profile would be a little higher but essentially the same.
3. Currency risk
Low-risk strategies can be exposed to importers and exporters within a particular country and, thus, to that country’s currency. For that reason, investors need to determine whether to hedge or not to hedge.
The bottom line, according to Bradley, is that pension investors need an active manager that pays attention and shouldn’t simply rely on a naïve implementation of low-risk equity strategies.
Alyssa Hodder is editor, Benefits Canada.