June 2011

EQUITIES: A sacrifice worth making

Roller-coasterLow-volatility equity strategies eschew growth to offer downside protection. But Nick Fitzpatrick finds the forfeit might not be so great after all
Why does volatility in stock markets occur mainly when asset prices trend downwards and less frequently when they rise? The answer is to be found in behavioural finance: people hate to lose money more than they love to make it. The fear of losing money when markets trend downwards is stronger than the desire to make it on the upside when an event offers investors potentially good returns, such as a regulatory change that increases prospects for an industrial sector.  In 2011, just as things seemed to be finally settling down once more after the volatility following the financial crisis, the recent earthquake in Japan and the political unrest in the Middle East and North Africa shook markets up again. Investors have had plenty of scrapes with volatility in recent memory, ranging from the Asian financial crisis (1997), through the collapse of hedge fund Long-Term Capital Management (1998) and the sub-prime mortgage meltdown (mid-2007], both in the US. So what do they do about it? Historically, very little it seems. They soon forgot any lessons they learnt about coping with volatility, says Ed Peters, co-director of global macro at First Quadrant, an investment boutique. Some time ago, First Quadrant developed its own volatility detector – the First Quadrant Market Risk Index. The needle on the dial is currently pointing at median. It combines volatility signals, such as growth and credit spreads, with the data given by a more established barometer of volatility: the Chicago Board of Options Exchange Market Volatility Index – better known as the Vix, or as the “fear” index. The Vix is used as a measure of volatility in the S&P 500 stock universe and is quoted as a percentage. In 2006 the Vix was a little over ten following a period of growth. But then came the “steady drumbeat” of the credit crisis, says Peters. “By late 2007, the Vix was at 25 and credit spreads were very wide – but people did nothing about it.” Things got much worse and by late 2008 the Vix was hitting 60. In 2009 it started to come down again but still spent much of the year over 30. Most of last year it was above 20; this year, below that. So far. So why do people not concentrate more on volatility when history shows that it periodically troubles them? “People get so focused on returns that they do not do anything about preparing for volatility,” says Peters. Could this be changing? Surveys in the past two years ranging from the UK to South Africa have shown that a chief reason for pension plan sponsors and trustees to change their asset allocation was to protect against market volatility, which in turn affects the volatility of their funding levels. Meanwhile, fund managers offering products or services designed to limit volatility in equity investments, such as low-volatility equities and minimum-variance strategies, say they have seen an increase in demand. These include Calamos Investments, a United States manager that is seeking to expand its European business and has global and US low-volatility equities strategies prominent in its offering; State Street Global Advisors (SSGA), which has developed an emerging markets-managed volatility equity strategy for Asia Pacific investors; Unigestion, the Swiss-based manager that won a global “minimum variance” mandate from Railpen Investments – manager for the £20bn (€22.9bn) Railways Pension Scheme in the UK; and Newton Investment Management, whose real return strategy seeks to absorb volatility and deliver decent growth. A low-volatility equities strategy aims generally to plot a path through a universe of equities by identifying the least volatile. They may also use equity-related instruments, such as derivatives or convertible bonds.  “We start from the basis of not wanting to lose our clients’ money,” says Terry O’Malley, head of European institutional business development at Calamos. “The attitude to risk is conservative.” While strategies like these are unlikely to outperform other riskier strategies in growth markets, it is the difficult periods when fund managers underperform that they are designed to work most effectively. And crucially, says O’Malley, these periods happen more than many people realise. “A low-volatility product does not necessarily mean low returns, but if you think we are heading into a raging bull market then it may underperform. However, there have been more periods of underperformance in financial markets than people think.” He says that since the inception of the Calamos Global Opportunities Strategy at the end of 1996 there have been 21 down quarters out of 60 in the MSCI World index. So which stocks or sectors count as “low-vol”, and why? One example is Swiss-based Novartis, the pharmaceuticals company, says Alexei Jourovski, head of equities at Unigestion, which has US$3.8bn (€2.7bn) of assets under management in its minimum variance strategies.  “Novartis is a stable business with low individual stock price volatility. It is traded in Swiss francs, which is a safe-haven currency. The Swiss franc goes up when markets go into turmoil, so it offers protection on the downside.” Utilities also offer lower volatility. They are non-cyclical, unlike consumer stocks and technology because, after all, people still need to stay warm and drink water whatever is wrong with  the economy. But events can quickly change the profile of the utility sector. An example seen recently was when the radiation leak in Japan affected utility companies that are linked to nuclear power production. Unigestion reduced its exposure to San Francisco-based energy company PG&E as a result. Mike Arone, global head of SSGA product engineering, points out that stocks from cyclical, higher volatility sectors like consumers can be found in portfolios designed to be low volatility. But this is not a bad thing. “You can find lower volatility stocks in the technology and financials sectors, although there are less opportunities, and you might want some of these in your portfolio for diversification benefits to make sure you’re not over-weighted to non-cyclicals.” There must be some growth generators in these portfolios to provide a certain amount of growth when markets move upwards. Being a low volatility fund that emphasises protection on the downside does not necessarily rule out upside gains. O’Malley, at Calamos, which has run a US-managed low volatility fund since 1989 and a global version since 1996, says: “We’ve delivered close to 90% of upside with less than 70% of the downside. Even if markets are going up we can deliver strongly.” John Burke, head of institutional business development at Newton, says the annualised return of its real return strategy, an absolute return fund, was 12.9% against a benchmark of Libor+ 4% between its launch on 1 April 2004 to end-February 2010. Volatility was 9% against volatility in the MSCI World index of 17.2%. Burke says: “If you break out the track record since inception between quarters where equity markets rose and fell, the value in trying to avoid negative compounding is demonstrated very powerfully. The fund increased 107.2% in rising markets, trailing the MSCI World index, which increased 178%. However, in falling markets the fund increased 6.9% while the MSCI World index was down 40.6%. In aggregate, this means the fund’s cumulative return was 56.5% above that of the MSCI World index.” Jourovski, at Unigestion, says its minimum variance strategies will fall by 0.6% if the market falls 1%, but they will also increase by 80 bps if the market goes up by 1%. “A growth period with no volatility is bad for minimum variance,” he says. “But growth with volatility is good. It was a bad year in 1999, but between 2004 and 2007, returns on minimum variance were above the index.” Investing a scheme’s entire equity assets in a low-volatility strategy will not immunise it completely from fund problems, but fund management firms say these types of strategies are increasingly sought as pension plans de-risk. ©2011 funds europe

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