Low-Vol Investing Is Not Unique to US Equity Markets

The benefits of low-volatility investing are present on a global scale, according to Aye Soe, director of global research & design at S&P Dow Jones Indices.

(August 30, 2012) — There are ways to achieve better risk-adjusted returns than what the market offers, and low-volatility investing is the answer, according to Aye Soe, director of global research at S&P Dow Jones Indices.

In April 2011, S&P released its low-volatility index, as have its competitors, such as MSCI and Russell.

“Low-volatility investing has been around for 40 years and finally caught on in the last three to four years largely as a result of the 2008 financial crisis,” Soe said.

The paper — titled “The Low Volatility Effect: A Comprehensive Look” — asserts: “Using the Sharpe ratio to measure the effectiveness of each strategy on a risk-return tradeoff basis, our analysis shows low-volatility strategies possess superior risk-adjusted performance over a benchmark portfolio. This desirable risk-return characteristic could have a profound portfolio management implication because the portfolio with a higher Sharpe ratio provides better diversification.”

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The paper continues: “It is nearly impossible to analyze the low-volatility effect without discussing the role of traditional equilibrium asset pricing theory. Hence, in addition to providing above-mentioned risk management capabilities, low volatility effect has reignited the debate on what constitutes a market portfolio or an optimal Sharpe portfolio, a tangency portfolio for which there is no other portfolio with the same or higher expected return with lower volatility.”

In April, Pim van Vliet, PhD, a portfolio manager at Robeco, told aiCIO that the lure of low-volatility stocks is their long-term performance. “The Netherlands was the first nation in Europe to really embrace the approach before the crisis, then over the last two years we have seen pension schemes large and small allocate to the strategy,” said van Vliet.

According to critics of low-volatility strategies, however, while a strictly low-volatility investing sounds like a strong idea, it is often an unrealistic way to achieve assumed returns. It is not possible to successfully meet return assumptions by moving down the efficient frontier. Instead, institutions must keep an eye on and guard against left-tail exposure while seeking a high enough risk strategy to surpass assumed return expectations. Pursuers of low-volatility strategies thus must be aware of its shortcomings, critics point out.

(August 30, 2012) — Reports predicting the death of equities have been greatly exaggerated, according to Ben Inker, head of the asset allocation group at Boston-based GMO.

“In a time when investors are questioning what role equities should have in their portfolios, it is worth understanding where the returns to equities come from, and why, after a 12-year period in which US equity returns have been negative, we can still be confident that the returns will, after all, be there in the long run,” Inker wrote in a paper.

The paper — “Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns” — outlines the following five points:

1) GDP growth and stock market returns do not have any particularly obvious relationship.

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2) Stock market returns can be significantly higher than GDP growth in perpetuity without leading to any economic absurdities.

3) The most plausible reason to expect a substantial equity risk premium going forward is the extremely inconvenient times that equity markets tend to lose investors’ money.

4) The only time it is rational to expect that equities will give their long-term risk premium is when the pricing of the stock market gives enough cash flow to shareholders to fund that return.

5) Disappointing returns from equity markets over a period of time should not be viewed as a signal of the “death of equities.” Such losses are necessary for overpriced equity markets to revert to sustainable levels, and are therefore a necessary condition for the long-term return to equities to be stable.

But as equity returns suffer a dismal reality in the short-term, what sectors should investors pursue? The investment environment is undergoing a “new normal” with asset allocation, according to a whitepaper by JP Morgan’s Joseph Azelby, Michael Hudgins, and Bernie McNamara, published in June. While equities have lagged over the most recent 10 years, with an annualized total return of 2.9% as of December 2011, “real assets” is one category that is fast gaining acceptance as an essential portfolio component. According to JP Morgan, the performance of global real assets bridges the gap between fixed-income and equity, noting that the asset class is characterized typically by investments in tangible “hard” assets that provide a blend of stable income, equity-like upside potential, inflation hedging, and lower volatility. In addition, the sector typically provides low correlations to the two current “traditionals”—equities and fixed income.

“These are difficult times for investors with volatile equity markets, low growth prospects in developed markets, and the threat of inflation,” McNamara told aiCIO. “With those circumstances, we’re finding that investors are looking to other solutions.”

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