Indeed, a growing aversion to abrupt price movements has been the driving force behind the recent popularity of low-volatility funds, and a case can even be made that such strategies actually perform better than their riskier counterparts.
Popularity contest
That low-volatility funds have captured the hearts of investors is hardly debatable. According to a paper from Research Associates, by the end of 2010 there were 27 such products on the market, amounting to $8.65bn (€6.4bn) in assets under management. In March this year, the number had risen to 72, and AUM had grown almost sevenfold to $58.47bn.
“Low-volatility strategies gained momentum in the second half of last year as a consequence of the financial crisis,” says Gordon Rose, an analyst at Morningstar. “Investors demanded products with less volatility that at the same time would not miss out too much on the upside.”
The popularity of low-volatility funds may be a recent development but the case for such strategies has a longer pedigree. As long ago as the ’70s, economists were using sophisticated mathematical models to demonstrate the old adage that high risks beget higher returns had less substance than people believed.
One of the most forceful proponents of low-volatility strategies was the economist Robert Haugen, who died in January. He started work on the so-called ‘low-volatility anomaly’ in the ’70s, developing the idea that market inefficiencies and flaws in classic economic models made a mockery of the concept that taking more risk increases the odds of better returns.
In the final year of his life, Haugen co-authored a study encompassing the performance of many stock markets around the world over several decades. The title of the study leaves little doubt about his conclusions: Low Risk Stocks Outperform Within All Observable Markets of the World.
A successful low-volatility strategy, however, goes well beyond picking stocks that move less than the market, or replicating one of the indices, explains Harindra de Silva, president of California-based Analytic Investors.
“The relative volatility of a stock and its correlation with market factors is very predictable,” he says. “Correlations of historical measures with future measures are generally in excess of 0.75. In building a low-volatility portfolio it is important to realise a stock’s overall volatility is less important than the risk an individual stock will contribute to the portfolio.”
He adds: “In building a low-volatility portfolio, as opposed to finding low-volatility stocks, investors should first identify stocks with low historical beta. They should then identify those low-beta stocks that have a lower price to earnings ratio than their peers in the same sector. A portfolio of such stocks will deliver in excess of market returns with much lower volatility.”
Possible pitfalls
However, investors must keep some factors in mind when picking a fund that follows such a strategy. Volatility is often derived from the current situation in a particular sector of the economy and, as a result, investors could find themselves exposed to unexpected risks associated to a specific kind of stock.
“The downside of some low-volatility funds is they could have a high level of sector concentration,” Rose says.
For instance, analysts say some of the products on offer are heavily tilted towards defensive equities such as utilities, consumer staples and healthcare. A shock in one of those sectors could make the low-volatility tag lose its meaning.
De Silva argues this should not be a problem if a fund is actively managed with a sophisticated strategy. “Low-volatility funds currently have high exposure to these sectors, but this has not always been the case,” he says.
“In 2004, such a fund would have been underweight utilities. A low-volatility portfolio will constantly move to sectors with lower correlation and low exposure to market movements. But it should not result in a portfolio that is highly concentrated in one or two sectors, unless the manager is using a faulty risk model.”
How attractive are you?
Another possible pitfall of low-volatility strategies is they only deliver the goods if the valuations of the stocks they invest in remain attractive. After all, one of the effects of modest stock price movements is that they provide neither an obvious entry point when companies are in trouble, nor an inflated rate of return when they return to favour.
Technology stocks, for instance, are rarely the stuff such strategies are made of – the idea is that valuations of low-volatility stocks tend to move less, no matter which direction the market is going.
The growing popularity of low-volatility investments, however, has helped boost the prices of many stocks that would be obvious choices to include in a portfolio. As a result, some analysts note that the best time to reduce volatility without sacrificing results may have already passed.
Other objections have been made against low-volatility funds.
Eventual rises in interest rates are seen by some analysts as potentially deleterious to such strategies. Investors who measure performance against particular indices can also end up unhappy as low-volatility stocks tend to present high levels of benchmark tracking error, especially when markets rally.
Investors could get nervous during a bull market if they see their low-volatility assets falling behind hotter alternatives. “Over a full risk cycle they will outperform by virtue of the fact that lower volatility will lead to higher cumulative returns,” De Silva says. “If you lose less in a market decline, you have less to make up in a recovery.”
On balance
The suitability of such strategies depends on an individual investor’s goals and risk appetite. Some advisers suggest that an investment in low-volatility developed market assets could be a good way to balance an increased allocation to emerging markets.
It is also useful to remember that low volatility is not the same as zero risk, particularly if funds are not properly designed.
“Investors have to look carefully at how these products are constructed, and at the pitfalls and flaws in their structures,” Rose says. “For instance, they may suffer from high sector concentration or benchmark hugging.”
It is likely, however, that the lure of a not-so-bumpy ride will continue to attract investors, especially those who have been hit by the events of the past few years and who have adjusted their attitudes to risk accordingly. De Silva says: “Low-volatility strategies are ideally suited to achieving high risk-adjusted returns, and are appropriate for investors where tracking error is not a concern.”
