Is the “Low Vol Trade” Over?
Despite the proven long-term effectiveness of low volatility (“low vol”) equity investing, many investors seem to agree with the flurry of newspaper headlines that suggest the end of the “Low Vol Trade”. However, at Voya Investment Management, we believe that the end of low volatility investing is nowhere in sight and that a well-designed lower risk solution, especially one with the opportunity for upside participation, may be one of the most compelling ways to generate long-term returns for investors.
So what do investors mean by the “low vol trade is over”? In the most basic sense, the low vol trade is the popular investment strategy of owning the lowest risk stocks in the investment universe in an effort to create an equity portfolio that outperforms when the market sells off. Over the long-term, “cushioning the blow” of a sharp downward move, such as the tech-bubble burst or the global financial crisis, helps protect wealth and allows investors to recover much quicker as markets normalize. Academics and practitioners have proven the case for low volatility investing — owning higher risk stocks does not mean generating higher compound returns as so many of us were taught in our finance classes. In fact, the low volatility phenomenon is just the opposite: investors gain more by losing less.
Why do Investors Think the “Low Vol Trade” is Over?
Naturally, with markets hovering around all-time highs and memories of the financial crisis still fresh on investors’ minds, having an equity portfolio that delivers downside protection in the event of a sell off seems like a reasonable investment strategy. And we argue that it is. So, why would investors think that the “trade” is over? After all, equity markets are still sitting around all-time highs even after this year’s volatile events such as Brexit and the increased uncertainly around global growth.
We believe there are two reasons why investors believe the low vol trade is over. First, the fact that investors think of low vol as a “trade” implies that they believe it is a tactical strategy. So for the past few years, to reduce risk and protect investment gains, many investors have supplemented their asset allocation by jumping on the low vol bandwagon and buying instruments such as low vol ETFs like S&P Low Volatility (SPLV) and US Minimum Variance (USMV).
Some active portfolio managers also tilted toward low vol by shifting their portfolios in the direction of more defensive, lower growth, higher dividend sectors of the market, such as utilities, REITs, and consumer staples. All of this maneuvering created an interesting dynamic in the marketplace — defensive sectors actually led the market higher (utility and telecom stocks were up over 23% in the first half of 2016!) while more cyclical sectors (industrials and technology) lagged. Consequently, as the price of the stocks in those defensive sectors rose, those sectors became more expensive and “crowded,” as did the low vol ETFs that followed them such as SPLV and USMV (Figure 1). Therefore, one could reasonably conclude that the low vol trade was ironically becoming riskier and due for a sell-off.
Figure 1. Valuations for Traditional “Low Vol” Spiked due to Defensive Sector Biases
A closer look at bond yields reveals the second reason why investors believe the low vol trade is over. With interest rates at generational lows (U.S. Treasury 10-year yield stood at 1.47% on 06/30/16), investors likely concluded that their bond portfolios were at risk when rates inevitably move higher. What investors also noticed was that low vol ETFs and funds parked in those defensive sectors were also at risk of higher rates, since defensive equity sectors tend to act like “bond proxies” with higher dividend yields and lower growth profiles than cyclical stocks. Once again, investors could reasonably conclude that if interest rates move higher, low vol allocations would be at risk, i.e. the low vol trade is over. And by and large, that is what has transpired so far over the second half of 2016. As interest rates moved up, low beta stocks have dramatically underperformed high beta stocks, and low vol ETFs have lagged the market (Figure 2).
Traditional Low Vol Strategies Have Underperformed with Rising Interest Rates
Voya’s Approach to Low Volatility Investing
Why do we believe that the reports of the death of low volatility investing are so greatly exaggerated? Because we believe that low volatility investing is not a tactical trading strategy — it is a long-term equity investment strategy. As a result, we believe that low volatility investment strategies that target higher long-term total returns with lower total risk always have a place in a broader, diversified equity portfolio.
However, that’s not to say that investors’ current concerns regarding traditional low vol approaches are invalid. So the question becomes: what is the best way to implement a low vol strategy? We believe that diversification across sectors of the market, or regions and countries in a global approach, mitigates the unintended consequences of many low vol strategies, such as interest rate risk or “crowding.” Furthermore, combining a robust source of alpha within low volatility portfolio construction provides opportunities to participate in rising markets, while still providing support on the downside. Overall, we believe this approach leads to a low vol strategy with a better risk/return profile (e.g., higher Sharpe Ratio), and is a more sustainable way to incorporate what should be an important component of any well diversified equity portfolio. We believe this approach can help investors avoid some of the pitfalls of strategies that focus purely on low volatility.
Past performance does not guarantee future results.
Index definitions: The S&P 500 Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights. The MSCI USA Minimum Volatility (USD) Index (US Minimum Variance) aims to reflect the performance characteristics of a minimum variance strategy applied to the large and mid cap USA equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, in USD for the lowest absolute risk (within a given set of constraints). Historically, the index has shown lower beta and volatility characteristics relative to the MSCI USA Index. The S&P 500 Index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses.
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