A nuanced low-volatility investment approach

One of the key motivations for investors moving away from market cap-based strategies comes from a desire to manage absolute risk and the belief market-cap investing exposes investors to risks for which they are not sufficiently compensated.

We saw this play out in the last quarter of 2018 as large-cap technology, or FAANG, stocks dragged down market performance in one of the largest routs in many years.

Investors have been turning to low-volatility strategies, as opposed to simple cap-weighted index funds, to better weather market drawdown events and help accumulate wealth over the longer term.

A number of low-volatility or minimum-variance products have been successful at lowering risk while also generating excess return over market-cap indices.

But low-volatility funds also come with downsides and the rise in popularity of such strategies may mask the fact there are hidden risks.

Axa Investment Management research has found one such risk is speculative valuation.

Many investors do not consider valuation adequately, especially as they ‘pay up’ for low-volatility stocks. Investors need to be careful not to trade out of an overpriced cap-weighted asset only to buy into an overpriced low-volatility asset.

A stock’s valuation becomes speculative when its stock price is significantly decoupled from the fundamental attributes of the underlying company – investors pay up for expectation rather than fundamentals.

We believe much of this can be explained by the behavioural and cognitive flaws of investors. People tend to prefer stocks that offer a small chance of an unusually large payoff, which pushes the price of such stocks up to heights not justified by the company’s underlying fundamentals. People also tend to overestimate their own ability to predict which stock will become the next ‘big winner’.

These biases can occur at a stock-specific level, sector level (for example, FAANG stocks) or asset-class level (for example, an oil rally).

To avoid overpaying, a thorough analysis of fundamentals can help mitigate these human frailties.

Another hidden risk we have found in many simple low-volatility approaches is extreme valuation.

Simple low-volatility strategies could expose investors to extreme valuations – both extremely cheap stocks and extremely expensive stocks. It is unsurprising a simple low-volatility approach has a wide valuation spread because portfolio construction in these approaches can be focused almost exclusively on low price volatility and does not take a view of valuation.

When we researched the returns generated by a simple exposure to low-volatility (low-beta) stocks that are also extremely cheap, we found they have lower return when adjusted for risk than the full low-volatility (low-beta) universe.

Importantly though, there is a difference between stocks that are cheap on a traditional book value dimension (price-to-book basis) and those that are cheap on a future earnings view (price-to-earnings basis).

We found exposure to low-volatility stocks that are cheap on a price-to-book basis led to lower returns when adjusted for risk, suggesting we can improve the outcome of a low-volatility portfolio by avoiding these stocks.

However, exposure to low-volatility stocks that are cheap on a price-to-earnings basis does not significantly lower returns when adjusted for risk, suggesting there may be some benefit in retaining exposure to some of these stocks within a low-volatility portfolio.

So generally investors can improve upon the risk and return outcome offered by low-volatility investing by systematically avoiding the extremely expensive stocks as well as the extremely cheap stocks.

Investors seeking defensive exposure to global equities are right to seek out low-volatility strategies. However, they should take a ‘nuanced’ approach to low-volatility investing to help avoid hidden risks and thereby help improve the investment outcome. A granular fundamental insight is required to identify and systematically avoid exposure to these risks.

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