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Investors are still awaiting the first rate hike by the Federal Reserve since June 2006. According to Bloomberg, since the last Fed statement, at the end of October, the odds for a December rate hike have risen from 37% to 48%.
And after the positive surprise in the most recent payroll report, the odds of a rate hike have risen still further – some say to 100%. It now seems only a matter of time before Fed Chair Janet Yellen will pull the trigger. In its last statement, the Federal Reserve no longer mentioned concerns about economic growth – concerns that had prevented Yellen from raising interest rates in the previous meeting.
This once again raises the question of what a rate hike – or a series of rate hikes for that matter – would mean for investors. Although it takes solid economic growth for the Fed to raise the federal funds rate, a hike is generally considered to be bad news for equity investors and certainly not good for bond holders. Low volatility equity strategies are also supposed to be more vulnerable in this environment as low-volatility stocks tend to behave like bonds.
In their white paper, ‘Interest-rate risk in low-volatility strategies’ (2014), Robeco’s David Blitz, Bart van der Grient and Pim van Vliet examined the sensitivity to interest-rate risk both of generic low-vol strategies and Robeco’s enhanced approach – which adds factors such as momentum and valuation to the strategy. They looked at both US equities over a longer period of time and global stocks over a more recent period. For US equities they looked at the period from January 1929 to December 2010.
They found that low-volatility strategies have a higher interest-rate sensitivity than a market-weight equity portfolio. It should be noted that the equity market is vulnerable to rising interest rates, but of course to a lesser extent than the bond market.They also found that interest-rate sensitivity appears to be about 25% lower for the enhanced low-volatility strategy than for the generic low-volatility strategy.
In their white paper, the authors claim “This suggests that enhancing a low-volatility strategy is not only attractive from a long-term alpha perspective, but it also has the additional positive side effect of reducing the short-term interest-rate risk of the strategy”.
They then went on to examine the interest-rate sensitivity of real life low-volatility strategies over a more recent period for a global universe. To this end, Blitz, Van der Grient and Van Vliet compared Robeco’s active global low-volatility strategy, Conservative Equities (which was launched in September 2006) with the first generic global low-volatility index, the MSCI World Minimum Volatility Index, which was launched in April 2008.
As this five to seven year period is too short to reliably estimate interest-rate sensitivities, they augmented this data with simulated returns for both strategies going back to June 1988. The sample period ended in September 2013.
The findings show that the performance of low-volatility stocks is positively correlated with the return on bonds. “What you see is that low-volatility stocks tend to underperform the market after an interest-rate hike, but this negative effect diminishes over longer investment horizons,” Van Vliet says. Generic low-vol strategies show a higher sensitivity to interest rates than Robeco’s enhanced approach, over both a 12-month and 36-month period.
“For Robeco Conservative Equities the relationship even appears to become virtually flat over a 36-month horizon. There might well be initial losses as a result of rising interest rates, but these appear to be mitigated or even entirely offset as time progresses.”
These charts show that Robeco’s active low-volatility strategy is able to mitigate interest-rate risk to a greater extent than a generic approach. The question is: what are the reasons for this lower interest-rate sensitivity? According to the researchers most of the reduction comes from the inclusion of valuation and especially momentum factors – these combined factors have less interest-rate sensitivity.
The fact that Conservative Equities not only looks at traditional historical volatilities and correlations also helps. In the enhanced strategy, the portfolio managers take forward-looking, non-statistical distress risk measures into account, and these measures also turn out to be less sensitive to interest-rate changes.
Does this mean that low-vol equities are still the place to be when the Federal Reserve turns the corner and starts hiking interest rates? According to data, global low-vol stocks offer an advantage. But for investors who are aiming to eliminate interest-rate risk, they may not be the right tool. As Blitz, Van der Grient and Van Vliet state in their white paper: “An investor may wonder whether it is a good idea to invest in the strategy if he or she expects a strong rise in interest rates in the near future. In our view, the decision to invest in a low-volatility strategy should be a strategic decision aimed at capturing the low-volatility premium. If the investor also has a tactical view on interest rates, the best way to implement this is to use instruments that provide direct exposure to interest-rate changes, such as bond futures or interest-rate swaps.”
‘A first interest-rate hike by the Fed might well be a non-event’
Should investors in low-vol strategies fear the rate hike? No, says Van Vliet. “A first interest-rate hike by the Fed might well be a non-event. It’s not only the direction of interest rates, but also their absolute level that counts. If the fed funds rate goes up to 0.25% or 0.50%, that hardly makes a 3% dividend yield on stocks look less attractive.” Over the past 90 years the dividend yield has been lower than interest rates most of the time. At the moment we’re far away from that situation. “But historically, it is normal for stock dividends to be lower than interest rates”, Van Vliet adds.
He does, however, understand the concerns that arise with a first interest-rate hike looming. “That’s why we researched the interest-rate risk on low-volatility strategies in the first place. We found that you can’t completely eliminate interest-rate sensitivity because you then change the character of the strategy. It becomes less effective in reducing losses, which is its first priority.”
For now, even if over the course of time, the Fed were to increase rates to 1%, it still would not necessarily be bad for defensive equities, Van Vliet thinks. “A potential turning point could be when interest rates match the dividend on stocks.”