Less risky, but more profitable – it’s an alluring sales pitch and one that traditional financial theory says should make us suspicious. But it’s one that low-volatility equity strategies have delivered on, for the most part, over the last decade. Like other equity factor premiums (such as value and momentum) the source of this success is largely attributed to the persistent behavioural biases of human investors.
This consistent outperformance has, reasonably, caused some to ask whether or not they should continue to invest in equity strategies that systematically target low volatility or whether it’s time to leave the party, so to speak. Detractors will argue variously that systematic low volatility equities look expensive and interest-rate sensitive or represent an increasingly crowded investment that no longer offers the scale of risk reduction it once did. Let’s consider each of these concerns.
Low-volatility equities look expensive
Low-volatility index valuations such as the price-to-earnings ratio (the price investors are willing to pay per $1 of current earnings) and the price-to-book ratio (the price investors are willing to pay per $1 of company assets) have been on a steady upwards trajectory. The price-to-book ratio in particular, often considered a more stable measure of value than price-to-earnings, makes low-volatility equities look expensive today, relative, to other forms of equity.
Eventually, high valuations do generally end up being a headwind for equities, but in the short-to-medium term, the impact of higher valuations is much less clear, particularly in a period of economic uncertainty.
Given this uncertainty, it is important for investors to consider the role an allocation to low-volatility equities is intended to perform. We take the view that absolute outperformance is a bonus, and that the primary role for an allocation to any form of defensive equity is to provide some downside protection when the worst happens and to improve the risk-adjusted return over the long term by delivering similar returns with lower levels of absolute volatility.
Shares that feature most prominently in low-volatility equity strategies have historically been more sensitive to interest rate moves than the broader market, performing worse when interest rates rise. Central banks around the world are increasingly looking to raise interest rates and this could have a negative impact on returns for low-volatility equity strategies.
Most evidence for this relationship is based on a fairly limited sample period, in which rate-rising scenarios have coincided with positive returns for broad market equities. As a result, it is not clear whether the historical interest rate sensitivity of low-volatility equities will outweigh their defensive characteristics in periods of market stress. In fact, we suspect that, in an environment of rising rates and falling capital markets, their defensiveness may be more important as investors seek the safety of companies with stable cash flows.
Popularity can have its problems, and the increased appeal of various factor-based equity strategies, including low-volatility equities, has some investors concerned about the potential for crowding in certain stocks. The concern is that a handful of names end up dominating portfolios and result in a liquidity squeeze and sharp price declines if these positions are suddenly sold.
Assessing this issue is difficult, as many investment funds are coy about sharing their holdings with outsiders, let alone their reasons for holding and criteria for selling; however, we can still look for some clues.
The estimated value of assets invested in low-volatility equity strategies compared with core equity strategies remains small. A qualitative assessment of the diversity of investors in some of the most prominent stocks in popular low-volatility indices suggests that the proportion of investors using a low-volatility strategy is also small. Finally, an analysis of a sample of actively managed low-volatility strategies and the extent that their investments overlap shows significant heterogeneity.
Overall, we find it difficult to conclude that crowding is a significantly greater issue for low-volatility equity strategies than it is for any other equity strategy.
The extent to which low-volatility equities have, in fact, reduced volatility relative to the broader market in recent years is less than in the past. On the surface, this supports a theory that the low-volatility anomaly is being traded away. As more people invest in these strategies, the benefit to each investor falls. The secret is out, so to speak.
As previously mentioned, however, we are skeptical that the weight of money invested in low-volatility strategies is sufficient to have such a material impact. Instead, we subscribe to a different theory.
We believe there is an element of cyclicality to the volatility reduction of low-volatility equities and that the recent trend towards less reduction is cyclical, rather than secular. Volatility has fallen generally for equity investments, and in any sort of significant downturn, we would expect low-volatility equities to exhibit less volatility than the broader market.
Overall, the concerns listed do not, in our view, individually or collectively undermine the case for an allocation to low-volatility equities within a diversified equity portfolio. There are clearly some potential headwinds for low-volatility equities, namely the impact of rising rates and high valuations, which may mean lower prospective returns (relative to the broader market) for these products, over the short to medium term, than many investors have become accustomed to getting.
The primary reason for allocating to defensive equity strategies such as low-volatility equities, however, is to provide diversification and improve risk-adjusted returns. Although in our view this rationale remains sound, investors could take some steps to protect their portfolios against some of the risks noted. Such precautions would include a greater use of active management and considering other types of defensive equity strategies, such as quality-bias and variable-beta approaches.
Rich Dell is global head of Mercer’s equity boutique and Ian Murray is a Mercer strategic research associate.