Low-volatility strategies have gained significant traction among investors. In the past five years, the number of such funds available in Europe has doubled to almost 100 open-end funds and exchange traded funds. Morningstar research finds that most funds have demonstrated compelling risk-adjusted performance, in agreement with academic research. The US equity market seems to be the hardest to crack for low-volatility funds.
Reducing Risk
Low-volatility strategies are designed first and foremost to reduce risk compared with traditional market cap-weighted indexes. Low-volatility funds have undeniably delivered on that front. Our data shows that, on average, these funds have been able to significantly reduce the levels of volatility when compared with their respective benchmarks and peers in the medium to long term.
Looking at our five regional buckets, we found that low-volatility funds had 11%-25% lower realised standard deviation versus market-cap weighted benchmarks during the trailing three- and five-year periods.
Low-volatility strategies available to European investors have successfully reduced volatility and drawdowns in all developed markets. Europe- and Eurozone-focused low-volatility funds have generated stronger volatility reduction and lesser drawdowns versus their respective benchmarks compared with US-focused funds.
This is partly because US markets have experienced strong returns on the back of stable economic growth, while the European recovery has been sluggish and more vulnerable to market shocks.
This has given Europe- and Eurozone-focused low-volatility funds more opportunities to shine. Also, we noticed that the edge of these strategies in terms of risk reduction and performance is much less pronounced in the more efficient US equity market where benchmarks have been tougher to beat for active managers compared with other regions.
Returns Are Not That Impressive
The study found that medium-term returns for low-volatility strategies are mixed. During the past three years, low-volatility funds on average have outperformed the MSCI indexes in Europe, the Eurozone, and globally, but failed to do so in emerging markets and the US. It should be noted that the low-volatility factor has performed poorly in most regions in the past 12 months up to February 2017, hence affecting the three-year numbers. All funds under examination in the study underperformed their respective benchmarks during the past 12-month period. The market rally driven by higher-beta stocks and sector rotation, notably towards energy, has been painful.
The returns for the trailing five-year period are not better. On a five-year basis, the average fund in only two buckets, Europe and emerging markets equity, recorded an outperformance. Low-volatility funds in global and especially US equity underperformed. It must be noted, however, that the number of funds with a five-year track record for most groups is sometimes substantially lower than for the trailing three-year period.
Looking further back in time, during a 10-year period, an even smaller number of funds were available to evaluate. Only within Europe equity do we have a sufficient number of low-volatility funds to say anything meaningful on their average performance. During a 10-year period, these funds are on average slightly behind the MSCI benchmark. Our medallists, funds with a Morningstar Analyst Rating of Bronze, Silver of Gold, on the other hand, have produced convincing relative returns in this timeframe.
All things considered, it is fair to say that the relative returns of the low-volatility strategies are a mixed bag. And especially in the highly efficient US equity market, they are less impressive than those obtained in other regions.
…But Risk-Adjusted Returns Are Compelling
Nevertheless, low-volatility funds shouldn't be judged only on returns, as the main objective for this type of fund is risk reduction compared with traditional cap-weighted indexes. A risk-adjusted gauge like the Sharpe ratio is a good way to measure the added value of these funds.
Over the most recent three- and five-year period, almost all buckets outperformed their benchmarks on a Sharpe ratio basis. On average, the outperformance is quite significant for low-volatility funds within Europe and Eurozone equity. Again, US equity is the exception. Although on a three-year basis low-volatility funds within US equity outperformed in risk-adjusted terms, they failed to do so on a five-year basis.
Meanwhile, medallist funds have done an even better job, as they outperformed the average for low-volatility funds in all five buckets during three- and five-year periods. With only one exception, medallist funds in US equity, however, did not match the average performance of low-volatility funds during the five-year period.
Morningstar recently published a study on low-volatility strategies: “Low Volatility: Searching for a Durable Edge”.
