U.S. Equities

Low volatility investing for the late cycle

Amid slowing economic growth and depressed market sentiment, cracks are emerging in how institutional asset managers have evaluated risk versus value during the recent 10-year bull market.
November 2019
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Amid slowing economic growth and depressed market sentiment, cracks are emerging in how institutional asset managers have evaluated risk versus value during the recent 10-year bull market.

To help navigate the changes, David Rosenblatt, Portfolio Manager at BMO Global Asset Management, offers a unique mix of theory and personal insight on how investors can not only survive – but thrive – as the cycle turns.

Shifting Sands in the Economy

Whether in the U.S. or across the world economy, there is mounting evidence that economic growth in the next two to three year period will differ significantly from the past decade.

Each morning brings a new tweet that can shift markets, impact global trade flows and cause greater volatility. Meanwhile, beyond the surface-level rhetoric and politically driven decisions, there’s still a macro environment which does not look particularly healthy: key yield curves are flat or inverted, global GDP growth has slowed, and key drivers of the economy such as auto sales, rail volumes, and industrial machinery production are all down. With leading indicators sending a clear signal, we find the onus is on bullish investors to tell us why the expansion should continue for a longer period of time.

The continuance of low (or even negative) interest rates also suggests that traditional asset allocation may not be as effective going forward. To be more specific, as risk spreads tighten and bonds become more expensive, it may be increasingly difficult to hedge equity exposure with fixed income investments. Without an appropriate counterbalance, we may start to see portfolio risk profiles change in ways that alter investors’ allocations and, consequently, their investment returns.

A Potential Answer to Rising Uncertainty

To mitigate portfolio drawdowns, many institutional asset managers have turned to low volatility strategies that seek to generate returns by reducing risk. Extensive empirical research has proven that names with low variance have outperformed higher risk counterparts over time, not only by reducing downside capture but also by skewing towards better quality holdings that produce sufficient income to withstand a downturn. Contrary to standard finance theory, which claims a positive correlation between risk and reward, the existence of a “low volatility anomaly” suggests human beings are wired to overpay for more speculative payoffs.   

This cognitive bias, known as the lottery effect, is borne out through decades of historical data. One study examined the performance of the largest 1,000 U.S. stocks (by market cap) over four decades, concluding that risk-adjusted returns have a clear inverse relationship, as shown below.

Equity Performance by Quintiles of Volatility, 1970-2011

Past performance is not a guarantee of future results.

Low volatility strategies are also particularly effective in up-and-down markets, a feature demonstrated by the simple, clear arithmetic of reduced downside capture. For instance, imagine two stocks with identical expected returns over time, but at different levels of risk exposure; one will experience 30% volatility, the other 10%. If both securities face tailwinds in Year 1 and equal-sized headwinds in Year 2, their performance would vary substantially. Counterintuitive though it may be, the chart below shows how lower risk equities can deliver outperformance by preserving more value during the downswing and compounding it over time, rather than simply capturing greater upside when markets are running high. 

Low-risk equity

Year 1 (+10%) x Year 2 (-10%) = 99% of Principal Value

High-risk equity

Year 1 (+30%) x Year 2 (-30%) = 91% of Principal Value

For illustrative purposes only, not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed.

How I Learned to Appreciate Risk vs. Value

Though the benefits of low beta stocks have been known to some degree since 1972, I first encountered the ideas as an undergraduate student dissatisfied with conventional theory. I had started down an economics path and began asking why it revealed only part of the story. From my vantage point, markets and institutions were made up of individuals who make decisions, and psychology seemed a natural complement to what I was learning. It appeared to show how the world exists, not how we think it should exist. But given that my school did not offer an integrated program at the time, it was incumbent on me to create my own “behavioral finance” degree – which I did, graduating with a double major.

While it took several years for me to transition to equity investing, and put my skills to the test, the DIY program certainly laid the base for an objective understanding of what drives value in markets; and then from a subjective point of view, how people process that information and make decisions that may or may not be ideal given the information they have.

Another crucial lesson came during my time working in consulting leading up to and then through the 2008 financial crisis. With our clients being mainly financial institutions, we focused on implementing robust risk management processes in order to fortify their businesses and strengthen their risk positions. For years after the crisis it was a constant fire drill trying to help fix problems that were previously invisible. One example that comes to mind is a mid-sized bank that was heavily involved in Florida real estate; during the recovery period, we worked with them to devise and execute a series of steps to re-build their internal risk controls. Unlike many peers, they survived.

Psychology seemed a natural complement to what I was learning. It appeared to show how the world exists, not how we think it should exist.

More importantly though, I gained an inside view of what could go wrong in a catastrophe. It opened my eyes to all of the risks that lie underneath the surface, or behind the curtains in a company, that to an outside observer might be hard to discern, but can mean the difference between being one of the world’s major companies and being insolvent. Looking back, it was the experience working in risk management consulting that taught me to take a more skeptical view of information that’s made publicly available or provided by management, given that whichever issues are “low priority” to them today could eventually become important. It taught me the true meaning of risk.

Achieving True Low Volatility

There are all kinds of approaches to defining low volatility. The first delineation is whether risk is examined at the individual security level, or for the portfolio as a whole. Portfolio managers in the former category naively sort investments from highest to lowest beta in order to carve out a niche at the bottom end of the spectrum, which can lead to portfolios that prove to be fragile in the face of changing risk regimes. True low volatility portfolios, however, measure the impact each holding has on overall risk, even if that means buying some slightly more volatile stocks that provide a hedging advantage.

How do you think about your benchmark?

The boundaries and dimensions of the investment universe is another important consideration. At BMO Global Asset Management, we have a global strategy that invests in developed and emerging markets of all cap sizes, which we think allows us to take the most comprehensive approach to lowering risk and really finding the best opportunities. If we were to limit our view to just large cap developed markets, our ability to discover assets that thrive in different environments would be severely reduced.

A third question to ask any low volatility manager is, “How do you think about your benchmark?” Many, if not most, have sector exposure rules that attempt to mirror the index, meaning that if there is 25% exposure to technology the strategy may have a mandate to stay between 20 and 30%. Consider the possibilities: in the event that technology assets become high risk, some low volatility strategies would still be required to invest a sizeable portion into the sector, based on their internal rules.

We take a differentiated, more holistic approach to risk management. Granted, our Canadian, U.S. and global low volatility strategies include common-sense limits on overall sector exposure to ensure diversification, but from there we really want to focus on gaining access to areas we consider high quality and low risk – regardless of how they compare to the benchmark.

Conclusion and Outlook

The 10-year market expansion, which peaked in the first quarter of 2018, was characterized by a barbell approach to risk where investors split interest between high growth, wide moat companies (mainly in the technology space) and firms that outwardly appeared low risk, such as utilities. While those two sectors were suitable for the extended post-2008 recovery, we are starting to see more skepticism about which firms qualify for the “low risk” label and which do not.

Though recent declines have been gradual and we haven’t yet seen a truly sharp downturn, this is precisely the environment in which low volatility strategies can deliver outperformance. After all, given that the inverted yield curve is an ominous sign with a good track record of predicting recessions, and there are presidential elections and ongoing trade war developments that can increase market volatility, it seems prudent for investors to adopt a defensive posture that can deliver in all market scenarios.

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This material is intended for institutional/professional investors; and is being provided for informational purposes only. The investments and investment strategies discussed are not suitable for, or applicable to, every individual.

The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain targeted returns and forward-looking statements, investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. Asset allocation and diversification do not ensure a profit or guarantee against loss. Beta is a measure of a portfolio’s volatility. Statistically,beta is the covariance of the portfolio in relation to the market. A beta of 1.00 implies perfect historical correlation of movement with the market. A higher beta manager will rise and fall more rapidly than the market, whereas a lower beta manager will rise and fall slower.

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