Volatility’s comeback and the many shades of low-vol investing
Market volatility has returned as interest rates have risen. Low volatility strategies offer investors a possible solution, but not all are positioned for a higher interest rate environment. Active approaches may offer greater portfolio diversification during volatile periods and, potentially, more opportunity.
The re-emergence of volatility
A calm 2017, followed by a volatile 2018
Volatility made a comeback. By extrapolating data from the CBOE Volatility Index (VIX), commonly known as the “fear index,” 2017 was a particularly fearless year. The median VIX was below its historical median of 18 (see dotted line). In fact, even the volatility spike we saw in 2017 (left side of graph) was below the historical median. In 2018, we experienced two volatility spikes, one in February, and another in October/November.
The February spike resulted in the closure of prominent ETFs that had bet against volatility. The October/November spike was triggered by heightened geopolitical tension, while the U.S. Federal Reserve raised interest rates, sold bonds in the open market, and let maturing bonds roll off (did not replace them).
Over the past five years, volatility has been dampened by historically low interest rates, creating a case of “a rising tide lifting all boats.” But as the cost of borrowing increased, volatility re-emerged as investors reassessed their portfolio risk and asset allocation strategy.
Historically, it has been relatively commonplace for the S&P 500 to produce a negative three-year return. In fact, from 1972 to the end of 2018, slightly less than a quarter of all 3-year rolling returns were negative. From 2013 to 2018, there were no negative 3-year periods. In fact, the lowest 3-year rolling return over that period was above 5%. This coincides with the global quantitative easing effort. With quantitative tightening underway, volatility has re-emerged and the abnormal, positive skew in returns has less support. Translation: buckle up.
Disproportionate gain to break even after a loss
This leaves investors with a conundrum. On the one hand, investors want to avoid a prolonged period of negative returns, but on the other, they don’t want to miss out on potential gains.
One approach is to invest in companies that have shown historically low volatility. Holding a portfolio of these low volatility equities may allow investors to continue to participate in the market while potentially moderating downside risk.
While low volatility equites tend to have lower downside risk, they also tend to reduce upside returns. However, because losses may not be as deep, they offer the potential for possible outperformance over a market cycle. This is because, as negative returns increase, it takes a disproportionate increase in positive returns to break even. For example, a 10% loss would take an 11% return to break even: a 1% difference. With a 40% loss, it would take a 67% return to break even, a 27% difference. This illustrates how losing less could lead to outperformance across a market cycle.
Passive versus active: Hindsight is not foresight
It should come as no surprise that investors can choose from various low volatility approaches in the market. The selection criteria range from simple, passive approaches to those that combine quantitative models with active security selection and portfolio management. A passive strategy is built on hindsight, investing in companies with the lowest historical volatility. Typically, they have a heavy overweight in consumer staples, telecommunication and utilities. Companies in these sectors exhibit steady cash flow but have limited growth opportunities and are generally considered bond proxies.
However, in an environment where interest rate continue to rise, excessive concentration in interest sensitive sectors might not reduce volatility. Furthermore, a passive strategy may not allow real-time company fundamentals to be reflected until a rebalancing date. Therefore, a passive approach to low volatility may represent a trade-off: simplicity in exchange for diversification and opportunity limitations.
An active approach for greater diversification
Boston-based MFS Investment Management, which manages the Sun Life MFS Low Volatility Global Equity Fund, uses an active approach. It divides the universe into 10 deciles (the 10th decile being the most volatile) but invests only up to the 6th decile. Compared to a typical passive screen, this allows for greater diversification across sectors and geographies. The team also set a maximum allocation on different sectors and geographies, based on the respective benchmark’s 5-year average.
The MFS team uses both qualitative and quantitative research to create a blended rating for any specific stock. Scores are adjusted based on analyst conviction and the weighting in a portfolio is based on the blended rating.
In volatile periods, low volatility approaches tend to draw greater interest. It is perhaps worth considering these approaches in all seasons of the market as, absent a crystal ball, one never knows when the storms will come.
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