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Seed Weekly - Low Volatility Factor Investing

Equity markets have been characterised by increased volatility in the recent past. Associated with this is the short-term underperformance in the markets, which investors are nervous about especially with more uncertainty going forward.

Figure 1 below illustrates how market underperformance and increased volatility have historically been associated using the FTSE/JSE All Share Index returns data.

Figure 1: Rolling 1 Year Return & Rolling 1 Year Standard Deviation of the FTSE/JSE All Share Index in Rand

Source: Morningstar Direct

This relationship is in line with the conventional risk-return trade-off principle which basically links, ‘high risk’ to ‘high rewards’. Volatility is a commonly used measure of risk – the more volatile an investment is, the more unpredictable future returns are, and the more likely they will deviate from expected returns.

My previous article on factor investing (smart beta), highlights certain factors which historically have been deemed to earn a long term equity risk premium. The target of factor investing is to harvest the risk premia through exposure to these factors. One such factor is the Low Volatility factor which by definition captures excess returns from stocks with lower than average volatility, beta, and/or idiosyncratic risk. Excess returns/outperformance from low volatility stocks is quite interesting as it contradicts the conventional risk-return trade-off principle stated above.

I make use of data from the MSCI All Country World Index as there is limited low volatility data on the local market. The chart below summarises why low volatility outperforms over the long term – simply it is a result of lower drawdowns / limited losses in times of market stress.

Figure 2: Investment Growth since June 1993 and drawdowns over the same period in USD

Source: Morningstar Direct

The long-term outperformance is quite remarkable as it points to the persistence of the low volatility factor, even though the main driver is limited downside. Such a strategy is likely to underperform when the markets are strong, but its strength lies in the period of negative market returns. The market tends to underestimate the frequency, magnitude, duration and impact of market downturns.

The MSCI low volatility uses two construction methodologies to capture the low volatility premium, minimum-volatility-indices and risk-weighted-indices. Minimum Volatility Indices reflect an empirical portfolio with the lowest forecast volatility using minimum variance optimization. Risk Weighted Indices capture low volatility stocks by weighting based on the inverse of historical variance. The result of this construction is a portfolio of stocks that tends to have more or less similar long-term returns.

A few behavioural explanations have been suggested to explain the low volatility anomaly. The “lottery effect” is the most common and suggests that people tend to take bets with a small expected loss but a larger expected win, even though the probability of a loss is much higher than the win, and the weighted average of the outcome may be negative – similar to paying a small sum for a potentially large lottery win even though the probability of winning is very small. Investors therefore often overpay for high volatility stocks and underpay for low volatility stocks due to the “irrational” preference for volatile stocks.

Critics of the volatility factor argue that buying a basket of low volatility stocks may lead to unintended bets on valuation and sectors, because such stocks can be expensive and concentrated in just a few sectors (such as financials). Continued analysis and testing is therefore necessary to optimise the potential benefits of investing in this factor.

The Seed Balanced Fund currently makes use of the Low Volatility factor as an equity strategy within the fund. Blending this strategy with other uncorrelated strategies forms part of our risk management framework. As a result, the fund has enjoyed diversification benefits, helping to reduce volatility in tough markets.

Kind regards,

Tawanda Mushore

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Fri, 19 Aug 2016

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