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According to economics textbooks, the more risk you take on, the
greater the return you can earn. A momentâs thought will show why
this has to be the case. If investors didnât receive any extra
compensation for buying riskier stocks, what would be the incentive
to hold them in the first place?
And yet the evidence suggests that precisely the opposite occurs
in practice:stocks with a recorded history of low volatility end up
doing much better than their riskier counterparts.
In a paper published last year in the
Financial Analysts Journal,
authors Malcolm Baker, Brendan Bradley and Jeffrey Wurgler looked
back at over 40 years of US share data. For each month, they sorted
the universe of shares into five groups, according to two measures
of riskâvolatility and betaâas measured over the previous five
years (the two risk concepts are closely related, but volatility
records the variability of a stockâs return, while beta measures
its sensitivity to the overall market).
In what Wurgler describes as a âspectacular anomalyâ, it
turned out that the least volatile stocks massively outperformed
the riskiest stocks over the four decades under review. The less
risk you took on, at least on a backward-looking basis, the more
you seemed to earn, in other words.
A dollar invested in the lowest-volatility portfolio in 1968
grew to US$58.55 by 2008 (or US$10.12 after adjusting for
inflation). But a dollar put into the highest volatility portfolio
at the outset was worth only 58 cents four decades later, or merely
10 cents in real terms, a 90 percent loss of purchasing power.
Thereâs an active debate about the reasons for such a
Investorsâ overconfidence in their ability to select
high-performing (and therefore volatile) stocks may be one cause of
the anomaly, suggest Baker, Bradley and Wurgler. In other words,
active fund managers may indulge in a counter-productive chase for
âwinnersâ as they seek to outperform their benchmarks. As the
performance of such high-momentum stocks has a tendency to go into
reverse, the low-volatility, less glamorous stock market
âtortoisesâ end up beating the âharesâ in the long run.
Another reason for the low-volatility anomaly may lie in
investorsâ choice of benchmark itself, and specifically in their
preference for capitalisation-weighted indices, say theÂ
paperâs authors. And it is active managers, rather than the
passive funds tracking the same indices, which are primarily to
blame, they suggest.
âThe typical institutional contract for delegated portfolio
management could increase the demand for higher-beta
investments,â write Baker, Bradley and Wurgler, suggesting that
the herd instinct of mutual fund investors could be amplifying such
âMutual fund investors tend to chase returns over time and
across funds, possibly because of an extrapolation bias,â they
continue. âThese forces make fund managers care more about
outperforming during bull markets than underperforming during bear
markets, thus increasing their demand for high-beta stocks and
reducing their required returns.â
However, Felix Goltz, head of applied research at Franceâs
EDHEC-Risk institute, has downplayed the low-volatility anomaly.
The widespread use of capitalisation-weighted benchmarks may indeed
increase the likelihood of short-term reversals in return from
high-momentum stocks, Goltz concedes, but the apparent
outperformance of low-volatility stocks may be reduced if you look
at it on a different timeframe, for example by conducting risk
measurements every two years rather than every month.
And, given that volatility is only one measure of risk (and a
rather crude one, since it doesnât tell us about the likelihood
of extreme movements), the positive âskewnessâ of many volatile
stocksâ returns may be missed by those talking of a low
volatility effect, says Goltz. In other words, investors may gain
from an additional, option-like payoff when owning high-performing
stocks like Apple or Google, while this inbuilt âoptionalityâ
is not measured by standard risk measures, like those for
volatility or beta.
Indeed, it is in strongly one-way markets that the
low-volatility strategy is most likely to underperform. In an
article to be published in the forthcoming March/April issue of the
Journal of Indexes Europe
Xiaowei Kang, director of index research and design at Standard and
Poorâs, notes that a low-volatility portfolio lost significant
ground against a capitalisation-weighted benchmark index during the
1999 technology bubble, and again in 2003 and 2009 during the
momentum-driven recoveries from cyclical bear market lows.
However, Kangâs figures also show that low-volatility
strategies can do particularly well in flat or down years for the
overall equity market. Since the turn of the millennium, 2000,
2002, 2008 and 2011 have been years of particularly strong relative
performance by such portfolios.
Investors should therefore be prepared for such periods of
divergent returns between low-risk funds and
capitalisation-weighted benchmarks, argues Kang. âDespite the
potential of alternative beta strategies (including low volatility)
to deliver better risk-adjusted performance than the market over
the long term, investors may need to be prepared for periods of
significant underperformance,â he writes in the
Journal of Indexes Europe
There is increasing evidence that investors are taking a
long-term view and are prepared to devote money to index-tracking
funds embedding such strategies.
Invesco PowerSharesâ ETF tracking the S'P 500 low volatility
index (NYSE Arca:SPLV) has raised over US$1 billion in assets in
its first eight months. The firm recently added two more
âlow-volâ ETFs to track emerging and developed non-US equities,
also based on indices from S'P.
In Europe, ETF issuer Ossiam, a subsidiary of Natixis Global
Asset Management, is building its ETF range around non-standard,
strategy-focused ETFs, and has now launched three funds that aim to
minimise fund volatility, the latest being listed on the London
Stock Exchange last week. Between them, Ossiamâs iStoxx Europe
Minimum Variance (LSE:EUMV), US Minimum Variance (
) and FTSE 100 Minimum Variance (LSE:UKMV) ETFs have around â¬200
million under management, representing 80 percent of the firmâs
Thereâs a fundamental difference in construction between
minimum variance and low-volatility indices, if not, apparently, in
the end-results. A minimum variance portfolio is arrived at by a
mathematical optimisation, using historical volatilities and
correlations between stocks as the inputs. As pure optimisations
can lead to imbalanced portfolios, constraints for individual stock
and sector weightings and for a minimum number of holdings are
often set as well.
As constraints for the FTSE 100 minimum variance ETF, for
example, Ossiam and the index provider set a 4.5 percent maximum
stock weighting and a 20 percent maximum sector weighting, with 50
shares as the minimum number of holdings.
Low-volatility portfolios are simpler in make-up, typically
ranking stocks by their historical volatilities and then weighting
them by the inverse of the volatility figure, with the least
volatile stocks receiving the highest weightings.
According to Kang at Standard and Poorâs, who compared the
returns of his own firmâs S'P 500 low-volatility index and
MSCIâs optimised minimum volatility strategy over a 13-year
period, both arrived at a similar reduction in volatility from a
standard capitalisation-weighted approach, reducing this risk
measure by about 20-30 percent. Although optimised, minimum
variance approaches should in theory reduce risk by more than
non-optimised strategies, the practical constraints applied to such
funds may dampen the reduction, says Kang.
Thereâs an overlap between low-risk index approaches and other
non-capitalisation-weighted strategy indices, for example
value-weighted portfolios or the fundamental equity indices
popularised by Research Affiliates, Alex Matturri, head of S'Pâs
index business, told IndexUniverse.eu. All these index methods
often end up selecting similar stocks, usually those with higher
dividend payouts, which produce a less volatile return stream to
end investors, Matturri clarified. Thereâs increasing interest in
replicating such market âfactorsâ via systematic, index-based
approaches, added Matturri, whose firm is building up its research
efforts in this area.
With 2012 off to a flying start for equity marketsâthe Stoxx
Europe 600 basic resources supersector index is already up 18
percent in Januaryâmany investors appear to be banking on the
idea that this year will be one for momentum-chasing. However, a
growing demand for strategy indices, including those promising low
volatility, suggests that a longer-term shift in investorsâ
portfolio allocations is also taking place.
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