"Chassez le naturel, il revient au galop" is a French saying that means "if you try and force out human nature, it will come rushing back at you."
Volatility-based investing has become popular for the right reason. Nevertheless, when that primary reasoning gets crushed by another logic we all tend to forget why we did what we did in the first place. That's human nature. The underlying premise for low volatility investing is to serve as a source of volatility reduction and diversification within a portfolio, a potentially attractive option to have in the toolkit.
Over the past couple of years, low volatility investing has experienced success1 and many investors have come to expect not only consistent volatility reduction but also the potential for consistent outperformance. However, any hint of a free lunch should have the rational investor's senses tingling. At the slightest reality check — or sign of increasing volatility — media murmurs start to build and emotion kicks in. Some investors that allocated to low volatility for the structural benefits that these strategies may provide are now trying to pursue the difficult game of market timing. While acknowledging the current market murmurs, we also should put things into perspective. Therefore, let’s address some of the questions we’ve been hearing.
Is low volatility a crowded trade2?
There are potentially as many ways to select securities based on risk as there are to select them based on valuations. We do not hear many references to value being a crowded trade. However, the popularity of a handful of low/minimum volatility products has attracted some scrutiny. To put things in perspective, large-value assets represent around 7% of packaged products, whereas risk-oriented strategic beta2 assets represent a meagre 0.3% of packaged products.3 This leads us to the think that ownership of individual securities driven by their risk characteristics may have a limited impact on price and crowding.
Are low volatility stocks overvalued?
Our research has led us to no real conclusion on low volatility stock valuations across different geographies. The chart below shows value exposure of low volatility stocks over time. Above 0 indicates higher exposure to value (i.e. relative cheapness) and below 0 indicates lower exposure to value (i.e. relative expensiveness). As shown in the chart, U.S. low volatility stocks remain in pretty neutral territory and Europe seems to be moderately richer, although nothing near extreme levels.
Are these strategies overly exposed to interest-rate movements?
It is important to distinguish defensive from adaptive. We believe the power of a thoughtful approach to low volatility investing resides in the ability to adapt over time because the perception of risk can change over time. With that in mind, low volatility exposure to value, momentum, small capitalization, etc., can fluctuate.
Today, the perception is that defensive positions (dividend stocks, utility companies, real estate, etc.) are interest rate sensitive. Yet there is potential for these segments of the market to be caught off guard by an abrupt increase in rates. If we were to take this thinking a step further, there is a likelihood that greater market volatility could ensue. Therefore, this would increase (not decrease) the need to minimize volatility through a diversified portfolio. This is why thoughtful strategy design is paramount. We believe it should focus on preserving the adaptive nature of a low volatility approach as not all strategies are created equal.
Overcoming emotion, maintaining focus
In conclusion, it is important to reiterate our belief that low volatility investing is all about reducing volatility consistently throughout time while offering the perspective of capital appreciation over a full market cycle. Until our ability to reduce volatility through risk-based4 stock selection is impaired, we strongly believe that all market murmurs are just that, murmurs.
Greed and fear are powerful forces of value destruction that investors need to face. But by maintaining an active focus on investment objectives — such as outperforming the broader market over a full market cycle while consistently reducing volatility — we think investors have the potential to overcome some of those challenges.
1 Source: The Morningstar strategic beta risk oriented category has attracted $14.2 billion in net flows year to date (end of October 2016). In 2014, net inflows were $2.1 billion and in 2015 net flows were $10.6 billion into the category.
2 Crowded trade: a security or investment theme that has attracted an unusually large number of participants.
3 Source: Morningstar- Strategic Beta Attribute, often called "smart beta," refers to a group of indexes and the investment products designed with strategic objectives in mind (low volatility, for example) that track them. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
4 Risk-based investing is a dynamic approach to asset allocation, based on managing risk.
Seeyond is a brand of Natixis Asset Management and operated in the U.S. through Natixis Asset Management U.S., LLC.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Understanding current market conditions and what might be expected in the near term.
Moderate model portfolio performance in 2016 was a tale of two halves.
Discussing the causes and potential consequences of the UK’s "Leave" vote.