A buffer in uncertain times

Q. Given investors’ current concerns over COVID-19 and the sharp drop in oil prices, how have low volatility strategies performed recently and how have they performed during similar episodes in the past?

Year to date¹, global equities as represented by the MSCI AC World Index are down 8.67% while its low-volatility equivalent (MSCI AC World Minimum Volatility) declined 2.89%. Over in Asia, the low volatility index (MSCI AC Asia Pacific ex Japan Minimum Volatility) has fallen 6.65%, which is modestly better than the broad market (MSCI AC Asia Pacific ex Japan) Index’s decline of 6.76%.

If we look back to the 2003 SARS epidemic, the Asian market declined by 7.1% while the Asian low volatility benchmark fell by significantly less (-2.0%) than the broader Asian market and the Hang Seng Index (-14.8%). See Fig.1.

Fig. 1. The MSCI AC Asia Pacific ex Japan Minimum Volatility Index fell less during SARS²

Likewise, in 2008, when oil prices and the Asian equity market corrected by 65.8% and 51.2% respectively, the Asian low volatility benchmark fell less (-40.6%). See Fig. 2.

Fig. 2. The MSCI AC Asia Pacific ex Japan Minimum Volatility Index fell less during 2008’s oil price correction³

Q. Low volatility strategies seem to be delivering what they promise in the global market – falling less during market downturns. Why does this effect seem less pronounced in Asia in the recent correction?

The low volatility effect has not protected on the downside as much as we would have expected in Asia Pacific this year. The key reason has been country effects, which have played out differently than in the past. For example, the China market – which tends to be more volatile – has provided more defensive characteristics in the recent (short-term) sell-off. Likewise, Thailand, a market that has traditionally been less volatile than the broader Asian market, has been less defensive this year as the virus outbreak has directly hurt its important tourism industry. In addition, the Thai market had already weakened earlier in the year on the back of macroeconomic headwinds which include the worst drought in forty years. Lastly, Singapore – with its significant ties to global manufacturing and China trade, provided little refuge in the global sell-off and has a bigger exposure in the Asia Minimum Volatility Index than in the broader market.

While it may be tempting to compare the performance of low volatility strategies and the market over the short term, the benefits from a low volatility strategy should be viewed with a longer-term perspective, i.e. over a full market cycle. Over short time periods, the returns from a low volatility portfolio may vary from the overall market due to country, industry, style or even stock specific effects.

Studies have shown that over the longer term, low volatility strategies deliver comparable returns and may outperform the broader market but with significantly less volatility (See “The Low Volatility anomaly: Examining the Evidence).

Q. What is the role active managers play when investing in low volatility stocks?

There is the risk that investors may pay too much for low volatility stocks, especially during periods of heightened market volatility when the appeal of such stocks rises. With increased indexing and passive flows, benchmark-sensitive equity investors have inadvertently left behind some low-volatility stocks that do not fit neatly into the index construction definitions. These stocks end up with superior risk-return potential. An active approach such as ours takes into account valuations during the stock selection process to tap into areas of the market that are mispriced. To further improve the portfolio’s outcome, we also screen out stocks with weak fundamental characteristics, such as those with poor profitability, quality, momentum and those where analysts are revising down their earnings expectations.

At the same time, we are not simply picking stocks with the lowest volatility characteristics. We also consider correlations and other risks including size and currency so that the stocks we select “interact” to create a low volatility portfolio. As a result, our stock, sector and country exposures differ from those of the low volatility benchmark. This differentiates our portfolio and makes it more diversified. Our active approach mitigates the risk of having too much exposure to sectors that are typically perceived as “low volatility” (e.g. utilities and healthcare), mitigating a concern that some investors may have with regard to sector concentration. We are also careful to diversify across countries which tend to be more volatile than sectors. This prevents us from having concentrated exposures in markets that may be less volatile for the wrong reasons, for example, due to lack of investor attention or illiquidity. As we have seen, countries can quickly become volatile due to sudden and unforeseen reasons.

Q. During these uncertain times, how can a low volatility strategy benefit investors?

The Federal Reserve’s 50 basis point rate cut in early March may prompt Asian central banks to follow suit. As mentioned in our 2020 Market Outlook (See “2020 Market Outlook – Quantitative Strategies”), falling interest rates tend to be supportive of the low volatility factor. That said, regardless of where rates are heading, our analysis suggests that low volatility strategies are more sensitive to changes in market volatility than to changes in yields.

At this point, there is still much uncertainty over the breadth and length of the COVID-19 outbreak. Much will depend on how the virus evolves, as well as the timeliness and effectiveness of each country’s response. During this period, markets are likely to remain volatile. See Fig. 3.

Fig. 3. Markets are likely to remain volatile⁴

The recent market corrections to date have made equity valuations more reasonable. Low volatility strategies are a viable solution for investors who want to take advantage of these cheaper equity valuations but prefer a more defensive stance as they are still worried about the market’s volatility. Low volatility strategies allow investors to participate in the market’s upside but experience less volatility, as these types of strategies tend to fall less during large corrections and, correspondingly, have less ground to make up when the markets go back up.

Tail risks are unforeseeable, and their impacts on portfolios are difficult to assess. Whether tail risks take the form of virus-related shocks, sharp oil price declines or other disruptions to the economy and financial system, long-term investors who are looking to de-risk their equity portfolios should consider incorporating low volatility strategies in their investment portfolios as a defensive allocation.