Better safe than sorry - why low volatility investing hits the spot
With the market outlook for equities remaining uncertain, analysts are advocating minimum volatility strategies, which are now outperforming market benchmarks
The high level of volatility gripping the global equity markets is expected to persist moving through the fag end of this year and on through the next, as tensions and uncertainties surrounding interest hikes and the ongoing trade war between the two largest economies continue to spook investors.
Under this scenario, investors are advised to switch to low volatility equity funds since they perform best in a high volatility market environment.
This advice - the return of the low volatility strategy - comes with the end of the robust performance of equity markets observed during 2017, when the markets were going in one direction, analysts point out.
Surging bull runs have been replaced with mood-dampening volatility. Indeed, the level of volatility has spiked since February 2018, based on the CBOE VIX Index. In 2018, the number of market swings rose markedly, with 29 swings during the six months from January to June alone, and this compared to 14 market swings experienced in the whole 12 months of 2017.
"A low volatility equity strategy performs best when there's high volatility in the market. This strategy focuses on the stocks that tend to be more resilient during drawdown days, weeks, or months. These stocks that don't go down as much don't have to recover as much when the markets do rebound," says Sarah Lien, client portfolio manager, Eastspring Investments.
On the institutional investor segment, Paris-based Seeyond Asset Management, the quantitative unit of Natixis Investment Management, has seen the assets under management (AUM) within the orbit of its minimum volatility strategies skyrocket to US$1 billion in the last year.
"If you think about minimum volatility investing, we've been doing it since 2010. But people always talk about the beta components of minimum volatility strategies. Our global strategy at the moment has a beta of 59%. It's an extremely low risk portfolio. Our European strategy has a beta of 0.7%," says Christiaan Kraan, managing director, business development, Seeyond Asset Management, the quantitative unit of Natixis Investment Management.
He adds, "But still some of these strategies outperform the growth markets. It's not just a risk reduction strategy,"
Seeyond has been diversifying its minimum volatility strategies by launching such strategies in the US and Asian markets.
"We've been doing the strategy on a European and global level since 2010-2011. We've launched Asian strategies, US strategies and also customized strategies for institutional clients," Kraan says.
Recently Seeyond has seen some institutional investors allocating a portion of their equity portfolio to minimum volatility strategies as a means of strategic asset allocation and diversification.
"Some of these institutional clients have allocated a component of their strategic allocation equity portfolio to minimum volatility investing. This is where it makes a lot of sense. You've got a strategy which has much lower risk than all the rest of your equity strategies. I think they're reducing it by 30-40%, and you put that in your strategic allocation," says Kraan.
For retail investors, Eastspring's Asian low volatility equity strategy, which currently has US$306 million AUM, aims to generate total returns in line with Asia Pacific ex-Japan equity markets, via a combination of capital growth and income, but with lower volatility.
"Last year, for example, when the markets were not volatile and going in one direction up, there was little interest in a low volatility strategy. While this type of strategy does participate in "up markets" it doesn't participate as fully as let's say a growth-oriented strategy. But in markets like we are in today, this strategy is outperforming the broad market and we are seeing good investor interest," Lien says.
This strategy mirrored the performance of its benchmark for the first half of 2018, but started outperforming the benchmark in July when the equity markets became more volatile.
The minimum volatility strategy is also designed to complement a typical balanced equity portfolio by providing diversification and improving the risk-return profile of the portfolio.
Going forward, Eastspring is still positive on the equity markets, although the outlook is for continued volatility in 2019.
"We're still telling our clients to invest in equities. The worst thing that investors can do is get really nervous about what's going on in the market, panic and then stop investing in the market. The mindset that I'll just get my money in cash and wait for things to settle down is risky because chances are investors will miss a really good entry point," Lien says.
Lien believes that Asian equities are now at a good entry point with cheap price-to-book ratios of 1.5x to 1.75x based on the MSCI Asia Pacific ex-Japan index. Buying at these current valuations typically produces higher returns over the long term, estimated at an average total return of 12% over one year, 26% over three years, and 55% over five years.
"When we look at low volatility stocks they tend to be located in more stable markets. Within our region, this has led us to overweight markets like Malaysia, Singapore, Thailand, and Hong Kong. Malaysia is a very domestically driven economy, the same with Thailand. The Singapore index is dominated by large, liquid, stable banks. We also have a lot of exposure to utilities and transportation stocks in Hong Kong," Lien says.
The more volatile markets in the region are India, South Korea, Taiwan, and China. But this does not mean the Asian low volatility equity strategy does not hold any stocks in those markets.
"We're actually underweight China but we're not unexposed to China. A lot of clients are surprised that a low volatility strategy would own something in India because that tends to be a more volatile market. But we do find good ideas in India, too. We don't have as much as the index but should India rally strongly after the election we will participate in that rally," Lien says.
1 Nov 2018