Sandra Haurant explains how low volatility doesn’t necessarily mean low returns when it comes to equity investing
There is something of a love/hate relationship between investors and volatile markets. Traditional thinking suggests that there could be a fantastic payoff for taking more risk - the greater the risk you are prepared to take, the greater the potential rewards may be. Sure, the flipside is that potential losses are also greater. But, year after year, in the past equity markets consistently outperformed to make these the asset type of choice for those needing certainty when it comes to returns over the long term. If you could afford to take the risk within a portfolio, and the potential rewards for pension funds were so great, why wouldn’t you do so?
Now, of course, things have changed dramatically. “Pension funds used to be quite relaxed about returns and volatility in equities. They almost always rose year on year, it was more of a question of by how much,” says FTSE managing director, relationship management, Carl Beckley. “But over the past decade, things have changed significantly. Returns are not so dependable and volatility has increased. There is no longer a certainty that they will pay off at the end of the day. Pensions need exposure to equities because it is such a large asset class, but there is no way of knowing which way things will go. How do you invest if you do not have a view?”
Add to these issues the fact that pension funds are under tremendous pressure to preserve capital and you have quite a conundrum, agrees Lazard Asset Management director, portfolio manager of global managed volatility strategy, Susanne Willumsen. “Many pensions are underfunded and assumed they would be rescued by the capital growth of equities, as they have been in past cycles. This time it is different and the economic slowdown has made pension funds re-examine their asset allocation in response to the ongoing market volatility.”
The classic bond/equity combination no longer holds water for pension funds, and an enormous variety of other assets have gained ground, including alternatives, diversified growth funds and, increasingly, low volatility equities. But how do these fit in with pension funds’ essential requirements – that all important balance of capital preservation and respectable returns? “Low volatility equities are a good match for the liability structure of pension funds,” says Willumsen. “Ideally you want 100 per cent capital protection and full participation in equity returns, which is obviously impossible. However, we think low volatility offers a nice blend of capital protection and participation, all at low cost.”
Such is the interest in low volatility, or minimum variance, equities that in July, FTSE launched a new series of indices to meet demand for this kind of stock listing. “We choose [stocks] subject to some constraints and in such a way that we get a fully diversified outcome, not concentrating on a particular region or sector,” says FTSE managing director, research and analytics, Peter Gunthorp.
The series has been put together using historic data and “aims to deliver reduced index volatility based on historical return information, thereby offering potential improvements to the risk reward trade-off, whilst maintaining full allocation to the relevant equity market,” as the series’ web page puts it.
Beckley explains that, in itself minimum variance or low volatility investing is nothing new. “In a way it has simply swung around again,” he says. “All investment runs in fashions and this is a sensible way of investing your equity allocation at the moment. But active managers have all had these forms of products from a very long time. With the new series, passive implementers such as Blackrock and L&G can take an index and run it passively, meaning lower fees.” And, of course, the index series also provides a benchmark against which investors can assess active managers.
Investing in low volatility equities may iron out excessive risks and bring about more dependable returns, but the concern for pension funds is that those returns will be lower once you remove the risk element. “It’s the cornerstone of investing,” says Lyxor Asset Management senior portfolio manager and global macro strategist Florence Barjou. “Lower volatility is usually thought to mean low returns.”
As such, for many pension fund investors it seems utterly counter-intuitive to move away from volatile equities and into equities that, at least according to received wisdom, will provide lower returns. “Some clients are reluctant to switch to low volatility,” says BNP Paribas’ investment arm THEAM CIO Denis Panel. “It is difficult for them to accept. They have to justify such a move, they feel they have to take some risk from the traditional market cap approach.” But in fact, he says, the concerns are unfounded.
It’s all about the ‘low volatility anomaly’. The widespread assumption is that greater risk is rewarded with higher returns is, it would appear, not necessarily correct. There is a considerable body of research out there suggesting that the inclination to equate volatility with higher returns over the long term is misplaced.
As Willumsen says: “It may be counter intuitive but, in the equity market, greater risk does not equal greater return. This is not true across other asset classes, and goes against the theory of capital markets, but in equity the evidence is compelling that low volatility stocks have outperformed high volatility stocks over an extended period.”
Perhaps bubble effects brought on by a rush for ‘exciting’ stocks, and the lottery-like quest for the big winners in the equity market mean that what goes up in price inevitably comes down and consequently returns suffer – something that does not happen with less sensational stocks. “People want to be invested in the highest market cap,” says Panel. “They are fascinated by stock such as Apple. There is that lottery ticket feel. An increase of 10 per cent in a stock’s value will not be life-changing, but if it quadruples in value it might be.” And that life-changing increase might be as enticing to a pension fund investor as it is to
anybody else.
Nonetheless, says Panel, pension funds are beginning to come around to a new way of thinking. “We think the low volatility anomaly will remain intact,” he says. “And as pension funds want to reduce risk, due to issues regarding funding ratios, they are becoming more and more interested in low volatility solutions.”
Indeed, Lyxor’s Barjou sees a significant movement towards these assets. “I think the key point is that the tolerance for drawdowns for investments has declined in pensions. There are very big issues around underfunding and they have to deliver returns while at the same time being very cautious around capital preservation. It is about maximising returns for a given risk budget,” she says.
“The pension funds we are working with are some of our most sophisticated clients,” says Barjou. “They are often first to be interested in the more innovative solutions. We are increasingly seeing strategies which are multi-asset based,” she says. Low volatility strategies are, of course, not restricted to equities and asset mixes and more varied allocation models are becoming more and more popular, according to Barjou, who says the natural path for low volatility investment will lead to even more innovation aimed at delivering attractive returns with lower volatility.
Striking that magical balance between achieving good returns while protecting capital is key to a pension fund’s success. With funding issues and reporting pressures, a fund cannot afford to get the risk reward weighting wrong. Which is why, according to FTSE’s Beckley, minimum variance or low volatility provides an eminently suitable strategy. “There is so much time dedicated to working out just what a fund’s asset allocation should be. If [managers] can sit around a table and say ‘We can manage to get the same or similar returns at lower volatility’ then that has to be an attractive approach.”
Written by Sandra Haurant, a freelance journalist
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