Low-Volatility Strategies’ Hidden Risks

Investors in low-volatility strategies may be doubling up their exposure to government bonds and interest rate risk, according to research.

“Smart investors take this exposure into account when considering to make an investment in strategies based on this phenomenon.”Funds focused on stocks with low volatility have been shown to outperform traditional indexes—hence their key role in the rise of smart beta—but they carry a “strong implicit exposure” to interest rates, said Joost Driessen of Tilburg University, Ivo Kuiper of Kempen Capital Management, and Robbert Beilo, an independent researcher.

“Our main finding is that the outperformance of low volatility stocks can be explained by differences in interest rate exposure,” they wrote.

The researchers calculated that stocks with the lowest volatility had a duration equivalent to a portfolio with 30% fixed income exposure. In contrast, the most volatile equities were equivalent to a 100% short position in bonds.

For more stories like this, sign up for the CIO Alert newsletter. 

“Smart investors take this exposure into account when considering to make an investment in strategies based on this phenomenon,” the authors wrote.

Investors are still being compensated for taking on interest rate risk, Driessen, Kuiper, and Beilo claimed: “We find a large premium for interest rate exposure in the equity market, a factor two to five times higher compared to the compensation for the same risk in the bond market.”

The findings echo a report from asset management boutique Greenline Partners earlier this year, which argued that low-volatility strategies’ outperformance was predominantly driven by falling interest rates over the past 50 years.

However, while the academics said investors in high volatility stocks were “implicitly short bonds, resulting in a drag on performance,” Greenline argued that this was unlikely to remain the case.

“We think [the falling interest rate] environment gave low-volatility investing a tailwind that will likely not repeat going forward,” the asset manager said.

Read the full paper, “Does Interest Rate Exposure Explain the Low Volatility Anomaly?”

Two of Europe’s largest pension funds have expanded their collaboration in sustainable investment ahead of a United Nations (UN) conference in Singapore.

“In the coming 15 years, we will need all hands on deck, and we will need a contribution from major institutional investors to achieve these goals.”In a joint open letter to institutional investors gathering at a UN Principles for Responsible Investment (PRI) conference this week, the CIOs of PGGM and APG said they were “closely collaborating” on investment projects with other Dutch asset managers and Sweden’s four main public pension funds.

“Our clients are explicit about the specific societal goals they want to align with; where they want to invest their beneficiaries’ money—not just where they don’t want to invest,” wrote PGGM’s Eloy Lindeijer and APG’s Eduard van Gelderen, who together oversee more than €600 billion ($675 billion). Dutch pensions are keen to invest in areas such as education and health care, the pair added, “without compromising on the financial result.”

Fund managers MN, Actiam, and Kempen have all “worked intensively” on such themes, alongside Sweden’s AP1, AP2, AP3, and AP4.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

“In the coming 15 years, we will need all hands on deck, and we will need a contribution from major institutional investors to achieve these goals,” Lindeijer and van Gelderen said.

The CIOs highlighted the importance of being able to measure the contribution made by each investment towards sustainable development goals—which could also help attract and retain customers. “This is work in progress, both for companies and investors,” they said. “Simultaneously, it is also a source of innovation and motivation.”

The “PRI in Person” conference in Singapore, which began on September 6, has featured contributions from major asset owners including the California Public Employees’ Retirement System, the New Zealand Superannuation fund, Japan’s Government Pension Investment Fund, and Australian funds HESTA and Cbus.

Representing @CalSTRS at the #PRIinPerson w 2 other staff, one of the FEW CIOs to participate. Making a difference ! pic.twitter.com/woDG6yW2xl
— Christopher Ailman (@CJAtheCIO) September 6, 2016

“Together we can change the world to make to make it a better place to live and retire in,” Lindeijer and van Gelderen concluded.

Last month, investors representing more than $13 trillion called on the G20 to implement high-level goals aimed at mitigating climate change.