MINIMUM VOLATILITY: Drawbacks of the safe bet

DominosThe most popular smart beta strategy of recent years has proved frustrating for investors after underperforming as volatility reduced and markets boomed, finds David Waller. Of all the smart beta factors, the minimum volatility weighting has proven to be the most popular in recent years. According to index provider iShares, minimum volatility funds had gathered inflows of $1 billion (€747 million) on a global basis in the year to July, with European-listed funds accounting for $300 million of this.   With minimum volatility, assets are weighted in an index according to their volatility rather than their market capitalisation. The lower the volatility, the higher their rating.  Hence a low volatility strategy works by looking at the volatility of each stock, and favouring those with the lowest – often those from defensive industries like utilities, where cash flows are very stable and incomes smooth.  All the major providers of indices will offer a minimum volatility index, on a global or regional level: S&P offers a low volatility 500, for example. FTSE offers a low volatility index as part of its RAFI series of measures. MSCI launched its Minimum Volatility Index in 2008.  “The index has proven very popular with a range of funds, from retail to institutions, and including the largest sovereign wealth funds,” says Altaf Kassam, head of EMEAI index applied research at MSCI.  Index providers will be the first to stress that the purpose of the factor is to evaluate the return/risk relationship of stocks, and compare that against the market – rather than focus solely on performance, as a market cap-weighted index does. Active fund managers haven’t ignored the listings – they’re offering funds targeting minimum volatility as a specific factor, whether via exchange-traded funds or other traditional mutual funds. In such a strategy, an optimisation process is often followed – where a computer picks combinations of stocks with both a low volatility by themselves, and a low correlation to each other – in order to construct an optimal portfolio.  As minimum volatility indices have a different focus to those weighted on market-cap, so the pursuit of a minimum volatility strategy requires looking differently at the whole criteria of buying stocks, away from straightforward performance. “We recommend reframing the concept of indexing,” says Ursula Marchioni, head of iShares EMEA equity strategy & ETP research. “It’s best to focus on the outcome of the strategy, whether that’s to enhance returns or control specific risks, and then consider how that strategy might fit within the current economic and investment landscape.  “Minimum volatility funds tend to work best when investors want to control risk during volatile markets, or for investors implementing long-term buy-and-hold strategies with a focus on risk-adjusted returns as opposed to absolute performance.” NOT RATIONAL
Yet there is one way in which a minimum volatility strategy can drive performance – by exploiting what’s known as the low volatility anomaly, an academically proven pattern that says low-risk stocks show a superior return/risk profile, or Sharpe ratio, in the long term than stocks with higher volatility. This isn’t rational, and there’s no clear scientific explanation behind the phenomenon. One theory is that as managers struggle to leverage growth portfolios, they’re going to those riskier stocks to get their returns. With managers being incentivised on generating outperformance, these stocks may become overpriced – creating a flat relationship between risk and return for the stocks.  “Usually you get rewarded more for taking a greater risk, so this low volatility anomaly feels counter-intuitive,” says Vinit Srivastava from the index research and design team at S&P Dow
Jones Indices.  “Lots of investors are leverage-constrained – they can’t borrow or buy more equities – so they instead buy high beta stocks, which give a better return than the market. But this also gives worse returns in a downturn.  “Humans always tend to think more of the upside: they buy high beta stocks, so they become expensive. And those low volatility stocks become less expensive, and this dichotomy persists.”  That’s the theory behind minimum volatility. So how does it work when applying this sort of strategy in practice?  “There are essentially two ways in which the low-risk anomaly can be approached,” says Jan Sytze Mosselaar, portfolio manager in quant equities at Robeco. LOW VOLATILITY
“First with a low volatility strategy, building a portfolio of low volatility stocks through a stock-ranking process.  Or one can adopt a minimum volatility/variance strategy: seeking the portfolio with the minimum volatility, involving a mean-variance optimisation process that includes correlations.  “We prefer the ranking approach, as it is more transparent, with logically explainable positions and no black box optimiser. This naturally leads to a lower turnover as it does not rely on normally unstable correlation estimates.” Institutional investors may use minimum volatility as follows: with a market cap exposure of 100, instead of replacing the whole strategy with a minimum volatility one, they may prefer to blend it – with 70% weighted on market cap, 30% on minimum volatility. This will reduce the portfolio risk overall, and with the extra risk budget that’s been freed up they can go and buy extra equities. UNSTABLE MARKET
As for when to employ a minimum volatility strategy, there is little debate: the strategy fares best when the market is unstable. The market has been on a sustained bull run for the past five years, meaning S&P’s low volatility 500, for example, has trailed the benchmark, but it shows a significant outperformance over the past 10 years.  And if you go back 15 years, taking in the crashes of both 2000 and 2008, the strategy proved very defensive and resilient.  “If the market is bullish, momentum and small cap indices will outperform, as everyone is happy to take on the extra risk,” says Kassam. “While minimum volatility works better when things wobble.” Sytze Mosselaar says: “The normal pattern is that minimum volatility reduces risk in falling markets,” he says, “While giving equity-like, or slightly better, returns in moderately rising markets, of nought to 15%.” Much of minimum volatility’s appeal may lie in the fact that it gives much lower drawdowns, so over time it tends to outperform the market.  “When you look at compounding over time, a minimum draw down in bad times is much more important than shooting the lights out when markets go up,” says one observer, “because it’s harder to repair a loss than it is to rebuild gains. It’s less exciting, but playing it safe in the long term is a good strategy – and minimum volatility is essentially a systematic way of playing it safe.”  Yet while minimum volatility may seem a suitably conservative and safe bet, and is probably the most popular of the smart beta factors, it does come with its drawbacks.  It’s worth considering that a minimum volatility portfolio can, for example, end up very defensive. While strong in bear markets, it will be likely to under-perform in boom markets. Utilities stocks, for example, will do well in times of turmoil but tend to lag when the market is thriving.  It may come as no surprise to learn, then, that the past few years haven’t been great for minimum volatility strategies, as both the US and European equities markets grew significantly. “We need to be up front about when this works and when it doesn’t,” says Kassam. HISTORIC LOW
“And in all honesty minimum volatility under-performed the market pace last year. It still did well, but the equity market was up around 30% in the US.” But that’s not to say it should be ignored. The minimum volatility game is very much about the long view, and while the level of volatility has been declining in most markets for two or three years, it’s now presently at a historically low level.  So the probability of it going up again is higher than the likelihood that it will go down further.  “There’s agreement that the market is fairly valued at the moment,” says Srivastava, “so you won’t see a run like last year where it went up 30%. As such, you need to seriously look at the minimum volatility strategy now.” TWO PITFALLS
Those tempted may wish to pursue the strategy together with another from the smart beta canon. Indeed, combining it with such an approach as value or momentum can be very effective, market participants say.  This helps to reduce the impact of two pitfalls that low volatility strategies can have – lagging behind in strong bull markets and the fact that low volatility stocks can become expensive – as is currently the case. ©2014 funds europe

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