Case for low volatility strategy looks robust after stocks spasm

By John Authers, Financial Times | juillet 05, 2016
Is low volatility better?

The past two weeks have witnessed an unusual and extreme incident of politically induced market volatility. As far as stocks are concerned, particularly in the US where the market is again close to its all-time high from May 2015, it appears to be over — although it would be unwise to ignore the sharp decline in bond yields since Brexit, which shows deepening concerns about economic growth.

For now, though, equity markets' round trip provides an interesting test case for the nascent discipline of smart beta. Now that it is fashionable to try to beat the market using rigorously mechanistic strategies that follow indices based on recurring factors, how have they performed in this strange environment?

And, in particular, we need to turn the spotlight on minimum- or low-volatility-style investing. Low-volatility investing has been popular with marketers, and produced fits among academics. They work on the idea that low-volatility stocks cushion the damage during a sudden downturn (like the post-Brexit spasm at the end of June). In the long run, there is research to show that a basket of low-volatility stocks beats a high-volatility basket.

This is a profound problem for financial theory. After all, if markets eventually reward higher risk with higher return, as they are supposed to do, how can low-volatility (and hence low-risk) stocks outperform in the long run? Can this possibly be a durable anomaly?

A further issue is that with any smart-beta strategy it is necessary to check whether it has become too expensive. A prolonged period of outperformance may merely show that it has grown too dear, and is ready for a reversal.

To get to the bottom of this, let us look at MSCI's long-term data on their minimum-volatility index, which has been turned into an exchange-traded fund (available from iShares), and has been back-tested to 1999 by Dimitris Melas, global head of equity index research for MSCI.

Over that period, which includes two epic collapses in 2000 and 2008, MSCI's min-vol US index has beaten its US index by 40 percentage points. As expected, it outperformed during all the big downturns. And it also suffered a prolonged period of relative underperformance during the past two years of the Federal Reserve's quantitative easing bond purchases, which helped to damp volatility.

Unlike the MSCI US index, it is now at an all-time high. And it trades at a valuation premium or a price/earnings multiple 9 per cent higher than the market. Historically, it has traded in a range from a 26 per cent discount in 2002 to a 28 per cent premium at the trough of the market in 2009.

At present, as MSCI points out, min-vol is within one standard deviation of its historic premium to the market, so it is not alarmingly overvalued, either.

Another way to approach the issue is via an attribution analysis. What attributes of the stocks in the min-vol index contributed in a statistically significant way to the outperformance? Once the MSCI quants crunched the numbers, they came up with the emphatic result that beta - the degree to which stocks tend to move in the same direction as the market — was by far the greatest factor behind the min-vol index's performance. The only other factor that had any significance at all was dividend yield, as low-volatility stocks tend to pay out a high yield.

So the research suggests that min-vol is performing roughly as it says on the tin, limiting downside when the market gets rough, and gaining its strength from the tendency of investors to flock to stable and boring stocks in times of turbulence.

In its latest test, the three days of US market alarm after the EU referendum, US stocks fell 4.3 per cent — while the min-vol index fell just 0.7 per cent.

So the case for min-vol looks robust, although its current valuation should signal some reason for concern. With that valuation looking high, now is not an obvious time to buy min-vol, unless you think that post-Brexit spasm in the US, so quickly reversed, is a sign that a bigger drawdown could be on the way.

If you do think this is a worry, min-vol does look like a sensible way to maintain exposure to equities over what could be a dangerous period.

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