Low-volatility funds have grown significantly in recent years and investors are learning the shortcomings of such strategies. It has long been evidenced that portfolios of low-volatility stocks have produced higher risk-adjusted returns in the long run than portfolios with high-volatility stocks in most markets. But it is only in the past ten years that low volatility investing has taken off in Europe.
The global financial crisis in 2007-08 and the Eurozone debt crisis of 2011 nourished a growing demand for lower-risk equity products that asset managers have rushed to satisfy. From a dozen specialised low-volatility funds 10 years ago, European investors today have access to around 100 low-volatility strategies, both active and passive.
We estimate that assets managed with a low-volatility approach across Europe reached €39.9 billion by year-end 2016 with a 15%- 85% split between passive and active strategies.
Interestingly, these funds have been particularly resistant in terms of flows. They saw net inflows even when their respective broader group of peers experienced net redemptions. For instance, in 2016 low-volatility funds investing in European equities registered modest but positive net flows of €156 million, whereas the broader Europe equity categories experienced record outflows.
Emerging markets shared a similar fate in 2015, with investors pulling a net €11.5 billion from global emerging-markets funds, but the low-volatility funds within this peer group gathered a net €900 million. The weakest spot seems to be in US equity, where low volatility has experienced modest growth. That said, overall these funds have racked up €26.9 billion in net assets since 2012.
The Pitfalls of Low-Volatility Investing
If low-volatility strategies have grown popular with risk-averse investors, they are not risk-free. Instead, low-volatility strategies typically trade some market risk for exposure to other potentially undesirable risks. Among the potential pitfalls to low-volatility investing is the reliance on past risk data. One can question the use of historic volatility as an indicator for expected risk in the future, even if correlations are not ignored.
Trailing volatility does not account for other information that may be available about a company, and there is no guarantee that the least volatile stocks historically will remain so going forward. Also, low-volatility portfolios have a high sensitivity to correlation estimates and can therefore carry significant concentration risk, as reflected in large biases towards defensive sectors such as consumer staples or utilities. That is why actively managed low-volatility strategies incorporate additional measures of risk, both macro and company-specific, in their risk assessment or apply forward-looking risk and return indicators in their stock-selection approach. Excessive sector or regional tilts are typically avoided by constraining risk-factor exposures or sector, country, and single stock weightings in the optimisation, or introducing factors such as valuation or momentum into the stock-selection process.
Value Investors Take Note
Excessive valuations are another looming risk. Volatility-reducing strategies that focus only on historical volatility do not factor in valuation. In some periods, low-volatility stocks become more expensive because risk-averse investors prefer defensive characteristics and stability. One legitimate concern is that the return of volatility-reducing strategies that have become more expensive might not be enough to compensate for the limited upside participation.
In our recent study, we show that in all developed-markets groups, low-volatility portfolios tended to be more expensive compared with the market-cap-weighted benchmarks when measured by price-to-book and price-to-earnings ratios. To limit exposure to richly valued stocks, active managers can take into account absolute and relative valuation measures whereas passive funds typically do not.
More recently, interest rate risk has appeared on low volatility funds’ radar. Low-volatility stocks tend to exhibit relatively stable cash flows because they tend to be less dependent on changing economic environments or operate in heavily regulated industries. When bond yields fall, minimum-volatility strategies tend to outperform the broader market. Equally, when bond yields rise, minimum-volatility approaches start to underperform.
Many years of falling rates have contributed to low-volatility returns, benefitting highly leveraged sectors such as utilities and telecom, which tend to be over-represented in low-volatility approaches, but this tailwind will likely be limited going forward. To counter this risk, active managers can implement interest-rate sensitivity screens or constrain certain sector exposures to control the degree to which a portfolio is exposed to changing interest rates. In this way, they can exploit differences in interest-rate sensitivity within sectors as well as across sectors to benefit from the diversification potential offered by stocks with diverging interest-rate sensitivities.
Actively managed low-volatility strategies are increasingly going beyond the traditional "minimum-variance" concept by using risk models that recognise the different sources of risk they are exposed to. Their enhanced models should potentially be able to reduce risk more effectively and better adapt their holdings to a changing market environment than simple low-volatility strategies that rely mainly on volatility and correlations.
