Risk-averse investors vs low-volatility strategies

Unlike in most legal systems where you’re innocent until proven guilty, there’s no such thing as presumption of innocence in financial markets. Basing decisions mainly on risk-adjusted performance, investors are the judge and jury. A bad month or quarter can have lasting effects on an otherwise sound investment strategy that may just be experiencing a transitory bump in its long-term performance.

That’s what happened to many low-volatility strategies during COVID-19. After delivering strong investment returns for over two decades, low-volatility strategies, in general, didn’t protect capital as well as their investors expected during the equity selloff in early 2020. The proverbial sentence was 16 straight months of outflows for low-volatility exchange-traded funds (ETFs), totalling nearly US $30 billion.¹

As volatility remains elevated, with persistent inflation risks and new COVID-19 variants threatening the economic reopening, defensive equity strategies may be particularly appealing in the near future. This makes it important to shed light on the subtle differences in the mandates of various low-volatility strategies, since they often have different investment methodologies and, therefore, results. In light of this, we feel it’s important to at least give low-volatility strategies a fair trial regarding the events of 2020 and examine whether they’re as guilty of not fulfilling their mandate as departing investors have suggested.

Risk-averse investors’ case: are low-volatility stocks suited for new market realities?

Over the years, low-volatility strategies have not only become a preferred solution for systematic investors trying to take advantage of the low-vol anomaly—which suggests that low-beta stocks tend to outperform on a risk-adjusted basis over the long term—but also a successful defensive strategy for risk-averse investors.

Low-volatility stocks significantly and steadily outperformed on a risk-adjusted basis

Value of $100,000 invested in 2001

At the height of the market panic in Spring 2020, however, low-volatility strategies weren’t able to hide when sudden global population lockdowns sent the S&P 500 Index down more than 30% in just 22 trading days. In fact, if we look at the downside capture ratio since the first COVID-19 case was reported in January 2020, we can see that the S&P 500 Low Volatility Index protected against a mere 4% of the market downside, well below its historical figure of 16% downside protection. Although the latter long-term number is more than respectable, it’s hard to argue against defensive-minded investors who were angry with a so-called defensive strategy protecting just 4% of the downside.

Moreover, low-volatility stocks struggled to keep up with the relentless market rally that followed. The S&P 500 Index gained 71% from the end of March 2020 through September 2021, more than double the 34% return of the S&P 500 Low Volatility Index. Although 18 months is considered a short period in financial markets, this underperformance begs the question: Are low-vol strategies just having a hard time during an unprecedented period or are they not suited for a “new normal?” A rhetorical question for sure, but looking at the outflow numbers, it’s safe to say that some investors are thinking it may be the latter. Our opinion: this created a buying opportunity for low-volatility stocks, as a whole, in an uncertain environment where equity valuations have become somewhat stretched.

Defence’s case: not all low-volatility strategies are created equal

While recent relative performance was below expectations, it’s important to note that a low-volatility strategy’s main goal is to deliver strong returns with below-market volatility. This allows investors to manage their portfolio risk budget more efficiently by carrying greater equity exposure and moving further out—and generally up—the yield curve for the same overall portfolio risk.

For example, Investor A has a 60/40 balanced portfolio invested in the S&P 500 and a five-year duration bond. Investor B has the same risk budget as Investor A but decides to build their equity portion with a low-volatility strategy, instead. Since U.S. equity low-volatility strategies typically have a beta between 0.7 and 0.8 (using the S&P 500 Index as the benchmark), Investor B can conservatively allocate 75% to equity, maintaining the same equity risk as investor A. Then, to match investor A’s interest rate risk, all investor B has to do is take the remaining 25% and invest in a longer, typically higher-yielding, eight-year duration bond.

Thus, when it comes to analyzing low-volatility stocks’ performance, we believe investors should put an increased emphasis on risk and capital efficiency. From that standpoint, low-volatility stocks haven’t disappointed, even during the height of the COVID-19 pandemic.

Low volatility stocks remained less volatile despite the COVID-19 turmoil

12-month rolling standard deviation

Moreover, not all low-volatility strategies are created equal. While the main criterion is usually the stocks’ trailing standard deviation, we believe there are additional, critical portfolio construction elements that investors should look for in a low-volatility strategy.

What are those key elements?

Sector diversification

Companies whose shares are the least volatile usually derive most of their revenue from long-term contracts (e.g., the utilities and real estate sectors), or from goods and services that are non-cyclical, like consumer staples. This results in significant sector over- and underweights in many low-volatility strategies.

This type of sector concentration has been particularly detrimental to the S&P 500 Low Volatility Index—and to strategies with similar methodologies—since the COVID-19 pandemic hit, hurting relative performance both on the downside and the upside.

At the peak of the market panic, the real estate and utilities sectors struggled alongside the broad market. This wasn’t at all surprising, as the companies in these sectors typically have high debt levels, and with credit markets all but frozen, companies that depend on debt sold off. Meanwhile, information technology names—which in a normal world, are cyclical and would normally underperform in down markets—performed relatively well, as trends of e-commerce and digital transformation accelerated, showing no signs of slowing down. Then, as financial markets rebounded, we witnessed a significant sector rotation, with cyclical sectors such as energy and consumer discretionary—sectors that tend to be not well-represented in low-volatility strategies and indices—outperforming.

The key to mitigating these effects is controlling for sector exposure. Financial markets—and the economic conditions that drive them—are unpredictable and constantly changing. Will oil prices reach $100 per barrel? Will inflation be transitory or persistent? How many rate hikes will the U.S. Federal Reserve make this year? These are the types of questions that market participants can only speculate on and that impact each sector differently. And to build an equity portfolio that’s more resistant as a whole, it’s important to have exposure to various segments of the economy to limit losses should any single industry get hit by a given market event. In fact, the main benefit of sector diversification is to help mitigate the risk of capital loss—by not keeping too many eggs in one basket—which is perfectly aligned with risk-averse investors’ interests.

Thus, while we believe that the main criterion in building a low volatility portfolio should be the underlying volatility of the holdings, we also argue that selecting the least volatile names within each sector while also making sure that each sector isn’t dramatically over- or under-represented can help avoid concentration risk and can provide investors with a smoother ride over time.

Company fundamentals

Downside protection can take different forms. Assessing a stock’s defensiveness based only on its historical price movements ignores one of the most crucial elements in stock selection: corporate fundamentals. High-quality companies with strong fundamentals, such as high and stable margins, low leverage, and superior return on equity, also tend to outperform the broader market during drawdowns. This shouldn’t be surprising. Companies with strong balance sheets and reliable cash flows don’t suffer from the same level of financial stress—from meeting debt obligations to paying out dividends —as their lower quality peers when economic activity slows. That usually transpires positively in their share price during down markets. In fact, we can see in the chart below that high-quality stocks better weathered the COVID-19 storm than low-volatility stocks and that investors combining low-volatility and high-quality stocks (50/50) enjoyed more stability (versus 100% low-volatility)—especially over the past five years—while still outperforming the S&P 500 Index on a risk-adjusted basis over the long term.

The combination of low-volatility and high-quality names generated more stable risk-adjusted returns

Five-year rolling Sharpe ratio relative to the S&P 500 Index

The crux of a defensive strategy is to protect capital against significant market drawdowns regardless of what causes them (e.g., pandemics, trade wars, bubble bursts). And to achieve that, it’s critical to find companies whose business makes them resilient to economic swings. At the end of the day, share price and volatility are a mere reflection of a company’s business and its fundamentals. When building a defensive strategy, scrutinizing these factors should be a key element in the portfolio construction process.

The verdict

Low-volatility strategies, in and of themselves, aren’t guilty of not meeting investor expectations. Some strategies are built by selecting the least volatile stocks from their universe—stocks that have historically been relatively stable. However, less-volatile stocks can often change and become more volatile in certain circumstances, which can be detrimental to investors, particularly when there’s an overconcentration in certain sectors and little or no focus on identifying quality fundamentals.

In our opinion, the best way to counter this phenomenon is to build a portfolio that also considers a company’s underlying resilience to the economic times, as well as controlling for sector exposure. Together, these elements help mitigate the effects of market drawdowns, ultimately leading to a smoother ride for investors.

1 Bloomberg