x Abu Dhabi, UAE Thursday 20 July 2017

Growing popularity of “low volatility” funds belies their effectiveness

In an environment where returns on pension funds’ traditional fixed income investments remain entrenched, the advice is clear: allocate money into asset classes seeking higher returns and take measures to manage the extra risks that they carry.

A trader works at the New York Stock Exchange. Carlo Allegri / Reuters
A trader works at the New York Stock Exchange. Carlo Allegri / Reuters

In an environment where returns on pension funds’ traditional fixed income investments remain entrenched at historical lows, the advice from consultants and other investment advisers is clear: allocate money into asset classes seeking higher returns and take measures to manage the extra risks that they carry.

This way, pension funds stand a better chance of meeting their increasing obligations to beneficiaries, while controlling the extra levels of risk.

Pension managers have evidently been taking note. The increased flow of pension-fund money into return-seeking assets is an important driver behind the recent strong performance in global equity markets.

It has also prompted pension funds and other institutional investors to significantly increase their investments in emerging markets equities. According to the specialist research firm eVestment Alliance, global institutional investors have added some US$240 billion to their emerging-market equity allocations since 2008.

To address the additional risks presented by such equity and emerging markets investments, there has been a recent proliferation of “low volatility” equity funds.

The attractiveness of these funds to institutional investors is clear – the potential for higher returns on the one hand and reduced risk around those returns on the other.

Indeed, given the outlook for European economic growth and today’s low interest-rate environment, low-volatility equity investing is set to become one of the principal investment strategies of the future. Low volatility funds are unleveraged, highly liquid and offered at much lower fees than alternative investments, such as private equity and hedge funds.

However, achieving good equity-like returns, while at the same time substantially reducing risk, is not easy. So how do fund managers go about reducing the risk in their equity portfolio without at the same time expunging the possible returns available?

One answer, which is proving popular among large institutional investors, is to construct portfolios that favour stocks that have been less volatile in the recent past.

The idea is that the overall volatility of the portfolio will reflect the low volatility of its constituent stocks. Investors in such strategies still hope to enjoy equity-like returns, without enduring as much risk as the broader equity market. This approach is often based on the widespread and likely flawed belief that less volatile stocks actually enjoy higher returns in the long run. This idea is known as the “low volatility anomaly” because it runs counter to financial theory, which says more risk is usually compensated by higher returns.

Some large providers of low-volatility equity funds adopt this method – particularly providers of so-called “passive” low-volatility funds. Such passive funds buy a bundle of individually less volatile securities, as described above, tilting the bias of the portfolio in favour of those securities with the lowest volatility of all. Pension funds have been allocating large amounts into these passive strategies as a cheap means of obtaining reduced-risk equity returns.

However, this simplistic approach is somewhat limited in effectiveness and capacity, and indeed may well prove counterproductive. The least volatile portfolio is emphatically not simply a combination of the least volatile stocks. Rather than simply picking low volatile stocks, actively managing the fund and considering the correlation between stocks is crucial in exerting far greater control over the portfolio’s overall volatility.

The advantage of the more simplistic approach to constructing low-volatility funds is that it can be very cheap. However, the limited ability of this approach to reduce risk starts to unwind the more assets are allocated to it. As investors put more money into such strategies, the valuations of these stocks increase, thereby diminishing their future performance prospects.

As such, large flows into some of the less sophisticated low-volatility strategies may well have a detrimental impact on their performance, unless capacity is constrained.

Yet there are alternatives to these simplistic passive strategies. Active managers are deploying more sophisticated low-volatility solutions for investors. For instance, constructing and actively adjusting the constituents of their portfolios according to their changing volatilities and correlations, and rebalancing accordingly. The most sophisticated are able to generate alpha to cover the costs of the associated higher turnover and fees required. The end result is less volatility and higher net returns than the passive strategies in the long run.

David Schofield is the president of Intech, a subsidiary of Janus Capital Group.