The United States was the first equity market in the world for which the low-volatility effect was documented. Portfolio manager Pim van Vliet discusses how he selects low-volatility stocks within Robeco Conservative Equities and explains why the strategy works in the US and in other parts of the world.
Stocks with low beta and low volatility realize higher returns than can be explained using the Capital Asset Pricing Model (CAPM). This anomaly, better known as the volatility effect, has first been documented in the US stock market. “The message of ‘lower risk without lower return’ is rather counterintuitive and surprising,” Van Vliet says. “As an investor, you would expect risk and return to go hand in hand.”
“The Conservative Equity strategy capitalizes on the volatility effect and works in different markets, because it is a global phenomenon,” he says. “The volatility effect has been documented in US, but also in European, Japanese and emerging equity markets. The research results from these markets indicate the same thing: equity investors overpay for risky stocks.”
“US Conservative Equities is the latest strategy of the Robeco Conservative range (that also includes Global, All Countries, Emerging and Europe) and was added in 2013. “This is a nod to the past given that the volatility effect was first documented in the US stock market, Van Vliet says. “However, we have had wide experience in selecting US low-volatility stocks with the Global Conservative Equity strategy, which was launched in 2006.” Besides US stocks, the universe of US Conservative also includes Canadian stocks.
The US economy recovered strongly in 2014 and in general investors have become more worried about the valuation of US equities. At the end of the first quarter of 2015, the MSCI US Index had a P/E of 19.1, compared with 16.9 for the MSCI Europe Index and only 13.2 for the MSCI Emerging Markets.
Moreover, worries about valuation especially apply to US low-volatility stocks. With a P/E of 21.9 for the US MSCI Min Vol Index, generic low volatility stocks are even more expensive than the US market index.
Van Vliet points out that the Conservative Equity approach also takes valuation into account when selecting low-volatility stocks. “In circumstances where generic low volatility is more expensive, it is especially important to take valuation into account. The P/E of our US Conservative equities portfolio is 17.9, which is considerably lower than a generic low-volatility portfolio and also than the US market as a whole.”
He believes history can provide answers on the effectiveness of the Conservative Equity approach during times when low-volatility stocks are more expensive, as currently is the case in the US. “Today’s environment resembles the 1940s and 1950s,” Van Vliet says. “The global recession of the 1930s was in the memory of most investors and as a result, stable stocks were in high demand, leading to higher valuations compared to the broad market.”
He has looked at a large US sample of 82 years and split this sample into two groups: ‘cheap’ where low-volatility stocks have a relatively low price-to-book ratio, and ‘expensive’ where they have a relatively high price-to-book ratio.
Within these groups, Van Vliet looked at a market index, a generic low-volatility strategy and the enhanced low-volatility strategy, which takes valuation and momentum factors into account. “I compared how well the market and two low-volatility approaches performed. The results of an enhanced approach were impressive.”
“The research shows that the return difference between the two low-volatility approaches is up to 6% per year on average in favor of the enhanced low-volatility strategy. This difference is largest when generic low-volatility stocks are expensive, like in today’s environment.” These results clearly emphasize the importance of applying an enhanced low-volatility approach which is selective and avoids buying defensive stocks which are expensive and have weak momentum.”
“Since 2006 we have selected low-volatility stocks with lower valuation and better momentum. This enhanced approach has resulted in a strong performance and a current portfolio with relatively cheap low-volatility stocks,” Van Vliet concludes.
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