On Fridays chief editor Peter van Kleef discusses thought-provoking topics with Robeco experts. This week: What to watch out for when selecting low-volatility products.
The growing interest in low-volatility equity products is of course increasing supply. It should come as no surprise that products with (virtually) the same description may be different.
Investors don't like large price fluctuations and that is part of the reason why volatility and risk are often referred to in the same breath. But the two are not synonymous. The real risk that investors run is the chance of permanent losses, not the hiccups along the way.
Many risk-averse investors are turning to low-volatility products to reduce the volatility of their equity investments. Demand has increased since the financial crisis, and so too has supply. And even though the decision to opt for low volatility is often made from the perspective of risk, it is also a good step in terms of returns.
While low volatility can often be more volatile than expected in the short term, the low-volatility feature of these strategies is most visible during down and/or relatively turbulent markets. In addition, the historical data shows that the returns from low-volatility shares are almost invariably better than the wider market return. The only requirement for investors is to use a horizon that includes a market cycle of both highs and lows.
Robeco research on the basis of data from 1926-2010 has demonstrated that the chance of a passive low-vol strategy underperforming the wider stock market over a period of three years is just 10%. And for enhanced low volatility, as Robeco uses in its Conservative Equities strategies, this rate is much lower still: 2%. The data since 2006 – when the first Conservative Equity strategy was launched – corresponds with these research results, says Pim van Vliet, portfolio manager of Quant Equities.
Robeco's Conservative Equities doesn't just take account of historical low volatility; it also factors in momentum and value. Interestingly enough, including these two extra factors in the long-term calculations doesn't produce a higher risk than the pure low-vol strategies. “Yet since 2006 this approach has been doing around 2% better each year than pure low-vol approach. Global Conservative Equities has achieved 8% a year since inception. Min Vol has achieved 5.9% and the market 5.2%.”
‘The risk with passive smart beta like Minimum Volatility lies in the fact that only historical data is used’
This too corresponds with the data that the research over the 84 years leading up to 2010 produced, says Van Vliet. The key reason for this is the addition of momentum and value. "The risk with passive smart beta like Minimum Volatility lies in the fact that only historical data is used," says Van Vliet.
“We also look at companies' balance sheets in order to map out the possibility of financial distress – the chance that they will get into difficulties. A company can have high and low historical volatility, but have blown up the balance sheet with loan capital. This can cause volatility to increase sharply. A second advantage of the enhanced approach is the portfolio's lower turnover rate.
“For some minimum volatility products, this can be well above 30%, meaning that performance can be reduced due to transaction costs. The average turnover rate for our Global Conservative Equities is around 25% – therefore a stock stays in your portfolio for an average of four years.
Another difference is that the Conservative Equities funds are not allowed to deviate from the index weight by more than 10% when it comes to diversification over regions, countries and sectors. This gives the funds room to maneuver, but prevents them from for example running an enormous exposure in a limited number of sectors, points out Van Vliet. “For a number of years, the S&P Low Vol Index had a concentration of almost 60% in just two sectors: utilities and consumer staples. Then you get huge 'style drifts', with all the associated risks when these sectors fall out of favor."
Stocks in the Conservative Equities strategies are selected for their low volatility, but value and momentum are also taken into account – stocks that are attractively valued or in demand among investors. “Over the course of the cycle the volatility reductions compared to the market since 2006 have averaged out at 26%, with a peak of 44% in 2008 – the year that Lehman Brothers collapsed. The higher the volatility of the markets, the more the strategy usually succeeds in keeping volatility in check.
The European regulator, ESMA, is also investigating the matter. The AFM has named passive low-vol products as a pertinent example and spoken to sellers of products with a noticeably high level of volatility about their provision of information. This mainly concerns the information they provide buyers on how volatility is measured.
It's a familiar picture for Van Vliet. “The crux of low volatility is that you lose less than the market in bear markets, but at the same time retain the ability to avoid falling too far behind when the tide turns, which means that you can achieve returns that match or are better than the market over a cycle of highs and lows."
"Reductions in volatility are usually visible over longer periods. The advantages become quite evident when you compare Conservative Equities strategies with the market over a period of at least one cycle."
The reduction in volatility has been visible since the inception of Global Conservative Equities. The data however is from a period of ever decreasing rates. Could a longer period of rising rates create a different, rose-tinted picture? Van Vliet acknowledges that low volatility may be sensitive to increasing rates. The enhanced approach can also prove its worth in such a market climate.
“Passive low vol is especially sensitive. This can be counteracted somewhat by adding value and momentum, generally leaving the strategy less sensitive to rate increases,” expects Van Vliet.
The many preferences and rapidly growing range of products are causing investors to ask what they should watch out for when selecting low-volatility products. Van Vliet lists five points:
This last point seems obvious, yet it's anything but. Many sellers of low-vol products use 'optimizers' in their portfolio construction. This usually involves examining the correlations between a basket of stocks. Selecting stock X because it has a low correlation with stock Y can result in lower volatility in the portfolio as a whole, but can however lead to the inclusion of stocks in the portfolio that have high volatility in themselves.
Van Vliet: “Products built with optimizers don't necessarily perform worse and don't by definition have higher volatility, but the way they work is however harder to explain. What you get is a kind of black box. And furthermore, mutual correlations over time are not stable, making it necessary to adjust the portfolio – with higher transaction costs as a consequence."
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