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Sunday 20 October 2019

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Trying times

Written by Lynn Strongin Dodds
November/December 2010

Against the current climate of unpredictable stock markets and economic outlooks, it is no surprise that low volatility equity strategies are gaining traction. The financial crisis highlighted the need for downside protection but as with many approaches, there are different variations on a theme. As a result, institutions have to read the fine print to ensure that the funds are meeting their specific requirements.

Lloyd Raynor, senior consultant, consulting and advisory services at Russell Investments, says, “We have identified about 17 managers globally in this universe and although they are mainly quantitative based strategies, they do have different definitions such as low volatility, minimum variance and managed volatility.

"I think though that most will not refer to it as minimum variance as the goal is not to choose just the least risky equities but those that reduce risk as well as outperform the benchmarks.”

Historically, investors would simply passively hold the market portfolio, according to the classic Capital Asset Pricing Model (CAPM) theory, believing that the specific risks inherent in individual stocks would be diversified away and the cap-weighted portfolio would provide optimal risk-returns. terms. The problem was that many of the underlying assumptions of the traditional CAPM were not borne out in practice.

This is not the case with low volatility strategies. The common thread running through is that they are designed to have significantly less volatility than the broad equity market but they aim to capture the equity risk premium over longer time periods. They also tend to have lower correlations to the overall market than traditional long only strategies. This is attractive to pension funds who are looking for a buffer against short-term volatility and better protection against large drawdowns, while still retaining the potential for upside returns.

Eugene Barbaneagra, portfolio manager and senior analyst of SEI, an early adopter of the concept in 2004, says, “Fund managers may present low volatility equity strategies in different ways, but in broad terms they are focusing on absolute versus relative returns. The goal is to deliver better returns in times of economic stress. We originally launched our fund to help pension funds better manage their assets and to provide downside protection.”

Mike Arone, managing director at State Street Global Advisors, says, “I think there a couple of reasons why there has been an increase in interest in these types of strategies. First the financial crisis is fresh in peoples’ minds as well as the fact that we had two bear markets over the past 10 years. The second is that regulatory and accounting changes particularly in the US, Europe and UK has meant that pension funds need to have a better match between their assets and liabilities.

"This has led to more liability driven investment strategies but pension funds still need to generate returns and a low volatility equity strategy allows them to have a reasonable growth profile with relatively low risk.”

Raynor adds.”I think many investors became disillusioned with the performance of cap weighted indices as well as active managers. As a result, investors are looking at a wider range of non-price strategies including equal weighted, fundamental weighted as well as low volatility equity strategies. We are definitely seeing growing interest especially from Dutch pension funds who will have pure active management and use these strategies as a diversifier.”

For example, Dutch fund administrator and asset manager PGGM, which was one of the first to embrace the concept, has roughly about 5-6% in minimum variance equity strategies. However, investment consultants in the UK are also encouraging their institutional clients to adopt this approach as part of their wider equity asset allocation. For example, in its recent paper, ‘Blueprint for Improving Institutional Equity Portfolios,’ Mercer calls on institutional investors to conduct a fundamental review of their equity portfolios to ensure they remain "fit for purpose" in the economic landscape post the financial crisis. It recommends combing high-growth components such as emerging markets and small cap stocks with a defensive, low volatility component.

Nick Sykes, partner and European director of consulting at Mercer, says, “We see two main themes in this area. There is the low volatility approach of buying defensive quality businesses that have relatively stable operations, balance sheets and share prices. The other called the systematic approach overweights those stocks whose share prices are low in volatility and underweights those stocks (or companies) whose share prices are relatively high in volatility. Whichever strategy is chosen, we see it as a component of the overall equity portfolio that would also include growth stocks such as emerging markets and small caps.”

Although the objectives may be the same other fund managers take a somewhat different stance. For example, Calamos which has a growth & income fund and global growth & income fund combines equities and equity-like convertible securities.

Martin Coughlan, senior vice president, senior portfolio specialist & head of institutional business says, “As an asset manager we take both a top down and bottom up approach and conduct a full capital spectrum assessment when doing our analysis. It is similar to the way a private equity firm values a company in that we want the broadest possible perspective. We use convertibles because they are hybrid securities and we see them as effective risk management tools.”

The theory is that convertible bonds are a way to get equity type returns with less risk or volatility. Calamos aim to look for bonds that capture a high percentage of the issuer’s stock appreciation but limit an investor exposure to price declines.

PanAgora , on the other hand, applies a risk parity framework when constructing its low volatility equity portfolios. This involves allocating stocks according to risk and not capital which creates a more efficient portfolio.

For example, a more balanced exposure between low volatility sectors such as utilities with those such as technology or financials. Edward Qian, chief investment officer for macro strategies at PanAgora, said: “If you are a passive investor you want the most diversified portfolio possible. However, investors will not be able to achieve this with a cap-weighted portfolio. This is because the majority of the risk is concentrated in a small group of stocks in an index. We believe that our approach creates a more efficient exposure to risk premium and offers broad exposure to sectors and stocks.”

Although approaches may vary, defensive stocks such as utilities, telecoms, healthcare and consumer goods tend to form an important part of the low volatility portfolio, according to Michael Fraikin, head of portfolio management at Invesco.

"The reason is that these sectors are less cyclical and stock returns are less volatile but sectors can change. For example, energy was considered less risky and a diversifier in a portfolio but that changes when oil prices rose. However, we do not have more than 2.5% of the portfolio in any one stock and we have concentration limits on industries and regions.”

As for the downside to this strategy, investors need to have a wide timeframe. As Arone puts it, “These strategies will outperform the cap weighted index over the long term. They will underperform in the short term and there may be the temptation to exit but investors need to have the fortitude to hold on.”

Investors will be rewarded if the academic studies are anything to go by. According to Roger Clarke, Harindra de Silva and Steven Thorley’s 2006 paper on the subject, which is often cited, a low volatility or minimum variance portfolio generated an annualised excess return of 6.5% compared to the 5.6% for an approximation of the Russell 1000 index, from January 1968 to December 2005. More significantly, volatility was reduced by 25%.

Pim van Vliet and David Blitz from Robeco Asset Management’s quant strategies team, on the other hand, found that the top decile of low-risk stocks achieved a Sharpe ratio of 0.72, compared with only 0.40 for the market portfolio.



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