What are low volatility equity strategies?
Low volatility equity strategies, also referred to as risk control strategy, target to deliver returns exceeding benchmark returns at significant lower downside risk and drawdown.
What is the meaning of volatility?
Volatility is a measure of stock’s risk. It is based on the magnitude and frequency of movements in a stock’s price over a given period of time.
If your portfolio contains too many highly volatile stocks, it is subject to big swings in performance. In a market decline, when high volatility stocks may plunge, low volatility stocks will typically retain more of their value. As a result you can preserve more of your capital in a down market and improve your overall performance in the long run.
How do low volatility strategies compare with traditional strategies?
Low volatility and conventional long-only equity strategies have similar return potential, but differ a great deal on the risk dimension. Low volatility strategies provide a smoother pattern of returns over time, with significantly lower drawdown during market crashes, but have larger tracking error from benchmark index.
How is low risk associated with high alpha?
While there is a positive relationship between risk and return across asset classes, the relationship within the equity market is very different. Stocks with lowest volatility have performed better than expected, while stocks with the highest volatility have performed much worse than expected. There is a clear case of low beta-high alpha and high beta-low alpha. Consistent with the evidence of a low volatility alpha, it is possible to construct portfolios with low volatility stocks that have had market-level returns or better and with much lower volatility.
What are the benefits of low volatility investing?
Potential benefits of utilizing a low volatility strategy include:
Is this post global economic crisis (2008) phenomenon?
No. In fact, risk anomaly is one of the oldest anomalies, yet till recently under-explored anomaly with early evidence traced back to 1970s. Researchers have noticed (Black; Haugen and Heins; Fama and Macbeth etc.) that relationship between Risk and Return is much flatter or even negative, contrary to the one proposed by CAPM. Series of studies from the beginning of 21st century have reported evidence for risk anomaly across markets over a period of time. InvestmentWaves is conceptualised based on proprietary research in this area.
How does LV Investing work?
Low volatility investment strategies, typically outperform during falling markets with much smaller drawdown and under-perform during sharply rising markets. Low volatility investment strategy would under-perform for sure, if return distribution is symmetrical as there are twice as many up months than down months over full market cycle. However, The extent of outperformance in downmarket is significantly higher than under-performance in rapidly rising markets and hence delivers not only lower volatility but also superior returns over a period of full market cycle. Over a long investment horizon, outperformance of low volatility strategy is more pronounced on account of compounding benefits. The logic is simple. As LV portfolio falls less on the way down, it needs less time to breakup on the way up.
For example, during a sharp market fall like the one seen in the second half of 2008, say if market as a whole represented by value weighted benchmark declines by say 50%, LV portfolio declines by 35% the value of Rs.100 invested in such strategies would fall to Rs.50 and Rs.65 respectively. Now, in a sharp recovery of 2009, market gains by 50% in no time and LV portfolio gains 35% during the recovery. In such a scenario, the value of market portfolio would move up to Rs.75, whereas value of LV portfolio would move up to Rs.87.75! Here, we assume beta of 0.7 for LV portfolio and zero alpha. In fact, as we mentioned earlier, the under-performance of LV portfolio is less during upmarket compared to its outperformance in down market. If we consider this, Rs.87.75 in our example may be much higher. No wonder, LV strategies deliver superior performance!
Is risk anomaly going to sustain?
Both individual and institutional Investors alike show significant preference towards high volatility stocks for various rational and behavioural reasons. Therefore they bid up the price of high volatility stocks, and make low volatility stocks attractive. This in turn drives outperformance of low volatility stocks and under-performance of high volatility stocks in the subsequent period.
In our opinion, as long as market participants face borrowing and short selling constraints, money managers have call option like payoff structures and investors exhibit irrational preferences for high volatility stocks influenced by preference for lottery, overconfidence, representativeness and mental accounting biases, risk anomaly is going to stay here. Will investors be able to overcome such biases? Only time will tell!
That’s fine, but is volatility predictable?
Yes, this is one of the advantages of low volatility strategies. While past returns don’t convey much about future returns, past volatility does a decent job of predicting future volatility. Besides, we don’t need to predict absolute volatility of the stocks. We are interested in relative volatility of stocks only. In summary, it is much easier to predict differences in relative volatility than differences in relative returns.
How do I fit low volatility strategies in my scheme of investments?
Low volatility strategies can fit well into any investment scheme in various ways.
o Increasing allocation of funds to equity without increasing the risk and therefore enhancing expected returns.
o At given level of equity allocation, it allows to pursue other aggressive alpha seeking strategies without exceeding the risk budget.
· Low volatility strategies has acquired status of separate asset class due to their unique reward-risk combination and therefore can be an important part of multi asset portfolio of large endowments or institutions.
· Low volatility strategies ideally fit individual investors investing to build retirement corpus or corporate pension plans investing to meet pension liabilities with long term horizon. It allows substantial wealth accumulation, especially by minimizing impact of major market crashes and drawdowns.
· Low volatility strategies tend to underperform during rapidly rising markets and outperform during falling markets, it lends great stability in combination to traditional passive and active benchmark tracking mutual funds and ETFs.
· Low volatility strategies, offers a low cost alternative to index funds, ETFs by offering comparable or better returns at a much lower risk to benchmark passive portfolios in the long run.
· Low volatility strategies, can be used in various ways in combination with pro-cyclical value and momentum strategies, or in combination of other classic smart beta or factor strategies such as size, quality and dividend yield to create unique risk-return trade-off. In addition, investors, open to core-satellite approach to portfolio construction can use Low volatility strategy as core and other aggressive alpha seeking strategies serve as satellite.
What is an appropriate benchmark for a low volatility strategy?
With much lower beta in the range of 0.6 to 0.75, standard value weighted benchmark indices are not serving as ideal benchmark. In fact, low volatility strategies are likely to have high tracking errors with respect to value weighted benchmark indices. However, it is possible to create an appropriate benchmark by beta-adjusting popular benchmark indices. For example if the low volatility strategy has an average beta of 0.7, then the beta adjusted benchmark would be:
0.7 * Value weighted benchmark index return + 0.3 * risk free return.
What can go wrong with low volatility strategies?
As such nothing much, if you are not worried about tracking error of your portfolio with respect to popular benchmark and only concerned about superior risk adjusted returns over a period of full market cycle.
However, in rapidly rising markets, when high beta stocks come into fashion as “get rich soon” tools, low volatility strategies tend to lag substantially and you may suffer from “missing the bus” syndrome during such times.. If you are an investor entering into markets with every rise with an intention to make quick money and leave the market after severe fall, you may not reap the benefits of low volatility strategies. Besides, in future, if investors become more rational and market friction goes away, in such ideal world, low volatility trade would become crowded and low risk anomaly will disappear and conventional “high risk – high return” relationship may re-establish. However, at the moment, such ideal world looks like a remote possibility. How will you know whether such ideal times are approaching? Well, we believe that, when you see people around you stop buying lottery tickets, exhibit great control in implementing their early morning walk schedules, start eating healthy food and give up junk food, that’s the time you think that low volatility advantage is about to disappear.