Fifty years ago, Bob Haugen and James Heins, studying the period from 1926 to 1971, first showed that over the long run, portfolios invested in stocks with lower volatility achieved greater average returns than those invested in more volatile stocks. This has not changed since 1971.
This low volatility anomaly is the backbone of low volatility equity investing, i.e., strategies that invest in the least volatile stocks with the aim of delivering risk-adjusted returns that exceed those of market capitalisation benchmark indices, and with less volatility.
Such strategies have tended to outperform market cap indices in bear markets and can still do relatively well in bull markets. If their volatility is not excessively low relative to that of the index, then they can produce the same or even higher returns than the market over entire macroeconomic cycles and, again, with lower volatility.
Low volatility anomaly in equity sectors
Our global low volatility strategy, launched in 2011, relies on in-house research showing that the low volatility anomaly was strong in all 10 equity sectors: Consumer discretionary, consumer staples, communication services, energy, industrials, information technology, financials, healthcare, materials and utilities.
Ten years after we rolled out the strategy, we showed that the low volatility anomaly in all sectors was still as strong as it was in our earlier research, explaining why its performance had matched our conviction. Our conclusions were summarised in a recent paper.
Good to be insensitive (to interest rate and inflation changes)
Not all low volatility stocks are alike. Some of the least volatile stocks come from sectors with a high negative interest rate sensitivity and tend to suffer in periods of interest rate rises or increasing inflation. Investing in such stocks can be a problem.
Our low volatility strategy is different. This is because it is set up to invest less in low volatility stocks in sectors that suffer when interest rates rise and more in low volatility stocks from other sectors. It does this efficiently, based as it is on a robust risk model and a well-designed portfolio optimisation approach.
How the strategy compares to traditional low vol indices
Not all low volatility equity strategies have been designed in this way. In fact, as far as we know, most low volatility strategies tend to suffer when interest rates and inflation rise. This is a huge drawback and can have disastrous consequences for investors.
The MSCI World Minimum Volatility index provides a good illustration of a low volatility equity strategy that suffers when interest rates rise or inflation increases.
We calculated the excess returns of this index beyond what can be explained by their low level of risk, i.e., its alpha, and divided it by its volatility to get the Jensen information ratio. Positive and high alpha and Jensen information ratio explain why low volatility strategies have higher risk adjusted returns than the market capitalisation index and may even out-perform it in bull markets.
In table 1, the last line, ‘full period’, shows that both strategies have positive alpha, but our strategy has a much higher Jensen information ratio.
To evaluate how the strategies performed when bond yields and inflation where rising or falling, we calculated the Jensen information ratio based on the average alpha in months when US 5-year bond yields increased, decreased, or did not move much, and similarly for inflation.
The results in Exhibit 1 speak for themselves. When interest rates rise, the MSCI World Minimum Volatility index has a negative alpha; when inflation increases, the alpha is almost zero, showing that this index is unlikely to perform well in such periods, in particular on a risk adjusted basis.
On the contrary, we expect our global low volatility strategy to generate higher risk adjusted returns than the market capitalisation index irrespective of the direction of interest rates or inflation. We would also anticipate it would outperform the MSCI World Minimum Volatility index by a large margin, notably in such periods.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.