For professional investors only. Low-volatility investing FROM THEORY TO PRACTICE

Transcription

1 For professional investors only Low-volatility investing FROM THEORY TO PRACTICE

2 Content Foreword 3 Introduction 4 History of low-volatility investing and the industry today 6 The basics of low-volatility investing 8 Robeco Conservative Equity approach 14 Use of the Conservative strategy in a broader portfolio 18 Robeco Emerging Conservative Equity Fund Key features 20 Investment team 22 Fund data 24 2 Low-volatility investing - From theory to practice

3 Foreword This guide describes the history and the basics of low-volatility investing, introduces the key features of Robeco s Conservative approach, and shows how we put theory into practice. For more than forty years studies have been carried out into the volatility effect. After the Capital Asset Pricing Model (CAPM) had taught us that risk and return should go hand in hand, empirical studies of equities showed that the relationship between risk and return is flat or even negative, as described by the volatility effect. Robeco has been a leader in successfully putting the theory of low-volatility investing into practice. We launched our first Conservative Equity strategy for developed markets in 2006 and an emerging markets strategy in We were also one of the first to make research contributions to the academic debate on low-volatility investing. With over AUD 7.8 billion in assets under management, Robeco can be considered one of the world s biggest active low-volatility equity managers. In addition Robeco manages AUD 3.3 billion in low-volatility credits. Low-volatility portfolios provide a huge opportunity to significantly reduce downside risk. This is achievable while maintaining full exposure to the equity premium in the long run. We hope this guide will give you insights on how to achieve your long-term investment goals using low-volatility investing. Rotterdam, March 2014 Pim van Vliet, Robeco Portfolio Managers Conservative Equities Arlette van Ditshuizen, Robeco Portfolio Managers Conservative Equities Guide to low-volatility investing 3

4 Introduction Introduction Low-volatility investing is rapidly becoming more popular. New low-volatility funds are being introduced and assets under management are growing, but what makes low-volatility special? From a theoretical point of view, what makes it stand out is the fact that it does not fit into the Capital Asset Pricing Model (CAPM). This model predicts that risk and return should go hand in hand. However, empirical studies of equities show that the relationship between risk and return is flat or even negative. This phenomenon is called the volatility effect (see Figure 1). From an investor s point of view, the volatility effect offers the prospect of equity returns at lower risk, thereby generating a superior Sharpe ratio, or better risk-adjusted returns. This ratio measures the expected return over the risk free rate divided by the standard deviation or volatility of this return. The Sharpe ratio indicates the extent to which investors are rewarded for the (absolute) risk they take. In other words, how much return they receive per unit of risk they take. It is important to realise that low-volatility investing is an accepted strategy which is adopted by institutional investors and backed by extensive academic research. For forty years studies have been carried out into the volatility effect. Robeco s researchers, David Blitz and Pim van Vliet, were early contributors to the academic debate on lowvolatility investing with numerous research papers that were published in various scientific journals. 4 Low-volatility investing - From theory to practice

5 Introduction Figure 1: Baker & Haugen (2012): evidence for 30+ countries Source: Baker, Nardin L. and Haugen, Robert A., Low Risk Stocks Outperform within All Observable Markets of the World (April 27, 2012). Robeco was also a leader in successfully putting the theory of low-volatility investing into practice. It launched its first Conservative Equity strategy for developed world markets in 2006 and an emerging markets strategy in This guide to low-volatility investing explains the history and the basics of low-volatility investing, and introduces Robeco s Conservative approach. Low-volatility investing - From theory to practice 5

6 History of low-volatility investing and the industry today History of low-volatility investing and the industry today Already in the early seventies empirical tests showed that there was positive alpha for low-beta stocks. Robeco has put these findings to good use by developing low-volatility strategies. Discovery of the volatility effect The low-risk anomaly was discovered many years before the valuation and momentum effects were documented, and just a few years after the CAPM was developed. The CAPM predicts that there will be a positive relationship between risk and return, where taking a higher degree of risk should, on average, be rewarded with a higher level of return. The first empirical tests carried out on the CAPM documented that the risk-return relationship is flatter than the theory predicts. In fact, a study by Haugen and Heins 1 (1972) showed that there was positive alpha for low-beta stocks in the period Subsequent studies by Haugen and others confirmed the existence of the low-beta and related low-volatility anomalies in later periods, not only in the United States but also in Europe and the emerging markets. Low-volatility investing at Robeco With over AUD 7.8 billion in assets under management 2, Robeco can be considered one of 1. Haugen, Robert A. and Heins, A. James, On the Evidence Supporting the Existence of Risk Premiums in the Capital Market (December 1, 1972). Available at SSRN: abstract= or 2. As of December Low-volatility investing - From theory to practice

7 History of low-volatility investing and the industry today the world s leading active low-volatility managers. In addition Robeco manages AUD 3.3 billion in low-volatility credits. Robeco was also a forerunner in terms of its research contributions to the academic debate on low-volatility investing. For example, in their publications, Robeco researchers were some of the first to prove that the volatility effect exists in Europe and Japan 3. Furthermore, they were the first to research and document the volatility effect in the emerging markets 4. Low-volatility investing today Today low-volatility investing has gained broader acceptance within academic circles and among investors. started in Since then, investors have become more open to alternative ways of capital preservation and diversification. There are no precise figures on the exact sums invested in low-volatility strategies worldwide. However, factor-investing strategies, where investors try to enhance the return-risk profile as opposed to following the traditional capweighted approach, are certainly becoming more popular. Following the success of active managers, passive managers have now also jumped on the lowvolatility bandwagon by introducing ETFs. Besides Robeco, a number of specialised boutiques were also at the forefront of lowvolatility investing and developed strategies in this field. Furthermore, several large asset managers have created mutual funds which try to benefit from the volatility effect. Low-volatility investing is also attracting more interest from institutional investors, especially in the wake of the series of financial crises that 3. Blitz, David and van Vliet, Pim, The Volatility Effect: Lower Risk Without Lower Return (July 4, 2007). Journal of Portfolio Management, pp , Fall 2007; ERIM Report Series Reference No. ERS F&A. Available at SSRN: 4. Blitz, David and Pang, Juan and van Vliet, Pim, The Volatility Effect in Emerging Markets (April 12, 2013). Emerging Markets Review, Vol. 16, pp , Available at SSRN: Low-volatility investing - From theory to practice 7

8 The basics of low-volatility investing The basics of low-volatility investing The basic approach is selecting stocks for a portfolio on the standard deviation of past returns. The Robeco Conservative approach includes other factors to enhance returns and reduce risk. How does low-volatility investing work in practice? Building a simple low-volatility strategy requires several steps: Select a universe of stocks. Calculate the monthly returns. Calculate the standard deviation of the returns and make a volatility ranking of the stocks from lowest to highest. Then select the stocks with the least volatility to construct a simple lowvolatility portfolio. Low-volatility portfolios aim to achieve risk reduction of 25% on average. Although this value varies across historical samples and economic regimes. Interestingly, risk reduction tends to be greater when market volatility is higher. The Robeco Conservative approach is an even better way to invest in low-volatility stocks as it aims to further improve performance by enhancing returns and applying a multidimensional risk approach. This is explained in more detail in the next chapter. Since its inception in October 2006, Robeco Conservative Equities has achieved volatility reduction of around 25% versus the market cap weighted MSCI World Index Robeco Performance Measurement. Monthly data from October-06 through October-13, gross of fees, based on net asset value of Robeco Institutional Conservative Equity Fund 8 Low-volatility investing - From theory to practice

9 The basics of low-volatility investing Table 1: Pitfalls and solutions of low-volatility investing Pitfall Robeco approach 1 One-dimensional view of risk Multi-dimensional risk approach 2 High trading costs Robust portfolio construction process 3 Limited up-capture and valuation risk Valuation and momentum factors in the stock-selection model 4 Concentration risk Strict concentration limits for region, country, (sub)sector, size and single stock weights Source: Robeco Since equity risk is the most important risk factor for most portfolios, low-volatility portfolios provide a huge opportunity to significantly reduce downside risk. This is achievable while maintaining full exposure to the equity premium in the long run. Four approaches for the most common pitfalls There are several potential pitfalls to low-volatility investing if the strategy is not implemented in the right way. The four common pitfalls and solutions are summarised in the table abov. Low-volatility investing - From theory to practice 9

10 The basics of low-volatility investing Pitfall 1 One-dimensional view of risk First, a low-volatility portfolio focusing only on past volatility has a one-dimensional view of risk. An important risk dimension is overlooked if we rely solely on historical statistical risk factors. Robeco approach Robeco adopts a multi-dimensional risk approach, which also includes forwardlooking risk measures in particular tail risk. The Robeco distress-risk model takes into account how balance sheet leverage might translate into future distress. It also incorporates other forward-looking financial information about the firm s corporate structure. Based on extensive testing over the period , Robeco has found that its distress-risk model has strong predictive power and is an effective indicator of future financial distress, such as creditrating downgrades or defaults. This predictive power is especially important to a low-volatility strategy, because one of its main goals is to preserve equity capital by minimising losses and realising positive excess returns versus regular market indices in down markets. 10 Low-volatility investing - From theory to practice

11 The basics of low-volatility investing Pitfall 2 High trading costs Second, a low-volatility strategy can lead to high trading costs, because of the high turnover. Low-volatility managers typically have a turnover rate of more than 50% and some in excess of 100%. At first glance, this might look like a relatively minor issue. After all, the impact of a single transaction on net performance is minimal. But when all the individually modest costs are bundled together, they can take a big bite out of net performance. Transaction costs are the silent killer of performance, making them a major consideration. Robeco approach Trading costs are an important consideration given that they directly eat into performance. This is especially the case in emerging markets where these costs are relatively high compared to those in developed markets. Robeco Conservative Equities has a robust sell-driven portfolio-construction process to limit turnover. Each position is held until the stock s ranking drops into the bottom 40%. Furthermore, our portfolio-construction tool does not take correlations into account, making the portfolio less prone to changes or correlation-estimation errors, which prevents excessive trading. Expected annual one-way turnover is only around 25%. This means that, on average, a stock is held in the portfolio for four years. Moreover, in emerging markets the strategy keeps trading costs low by selecting the right type of security to trade. For example, in some emerging markets Robeco holds depositary receipts instead of the underlying local shares of the company in question. By trading these alternative securities, the strategy effectively reduces the market impact, FX conversion costs and taxes. Guide to low-volatility investing 11

12 The basics of low-volatility investing Pitfall 3 Limited up-capture and valuation risk Limited up-capture: due to its focus only on risk factors, a simple low-volatility strategy tends to lag during a market rally. Valuation risk is the risk of overpaying for low volatility stocks because the actual price paid for a stock is ignored. Most simple low-volatility strategies do not take valuation into account. At some periods in time, low-volatility stocks are more expensive. This was the case in the 1940s and 1950s, when people were willing to pay for stability, which resulted in relatively low returns in the following years. Robeco approach In order to enhance the risk-return profile Robeco Conservative Equities has added return factors to its stock-selection model. Adding momentum factors, such as earnings revisions, helps to improve up-capture, while adding valuation factors mitigates valuation risk. Incorporating these two factors into a low-volatility strategy enables us to realise our objective of maximising Sharpe ratios, as these improve across regions, countries, sectors and sample periods. 12 Low-volatility investing - From theory to practice

13 The basics of low-volatility investing Pitfall 4 Concentration risk Indices and optimised portfolios can carry concentration risk. The S&P 500 Low Volatility Index is a good example. It does not constrain sector weights, resulting in a huge sector concentration. For example, in December 2012 around 60% of this index was invested in only two sectors, utilities and consumer staples. This means that any sector rotation or sector-specific developments can have a large negative impact on total performance. Optimised portfolios can also carry concentration risk. These portfolios are highly sensitive to correlation estimates which are used to construct the portfolio. This might result in extreme portfolio positions. Robeco approach Robeco mitigates concentration risk by having strict concentration limits for region, country, (sub-)sector, size and single stock weights. Furthermore, Robeco combines a wide range of low-correlated factors in its selection model such as low-volatility, valuation and momentum. This leads to a varied stock selection avoiding style and factor tilts. Guide to low-volatility investing 13

14 Robeco Conservative Equity approach Robeco Conservative Equity approach Robeco takes a prudent approach to constructing a portfolio. Its aim is to maximise exposure to high ranked stocks while adhering to concentration risk, and keeping portfolio turnover low. Stock Selection and Portfolio Construction Stock markets are not fully efficient - there is frequent stock mispricing or other anomalies. Robeco believes systematic investment strategies are able to exploit these biases through the creation and application of quantitative stockselection strategies. These strategies have been developed to maximise exposure to high ranked stocks while adhering to concentration and position limits. This is a pure bottom-up strategy. The factors used in the Conservative Equity stockselection model include: 1. Low-risk factors to capture the low-risk anomaly. 2. Additional risk and return factors to enhance the risk-return profile. Figure 2 explains how including additional factors aims to reduce risk and enhance returns. The Conservative approach offers the opportunity to achieve equity returns while significantly reducing risk. Conservative Equity can also offer good opportunities for income generation. Lowvolatility stocks are generally characterised by above-average dividend yields. 14 Low-volatility investing - From theory to practice

15 Robeco Conservative Equity approach Figure 2: Addition of factors aims to reduce risk and enhance returns Return Conservative Equities Broad portfolio of low volatility stocks Single statistical risk measure Low conviction, large number of stocks Robeco proprietary low-risk factors Combination of statistical risk factors Proprietary distress factors Source: Robeco Low Risk factors Risk Low Volatility Robeco Conservative Equity Integration of valuation and momentum factors High conviction, higher active share Low-volatility investing - From theory to practice 15

16 Robeco Conservative Equity approach A prudent approach to portfolio construction Robeco s approach to portfolio construction consists of three phases: ranking, portfolio construction and cash flow/rebalance. Figure 3 shows how Robeco manages Conservative Equity portfolios. (1) The first phase of the portfolio-construction process starts with a new quantitative stock ranking. The new ranking is subject to plausibility checks, both by Quantitative Research and the portfolio management team, particularly for those stocks that exhibit significant changes in their ranking. (2) The next phase consists of model portfolio construction. The model s results are implemented by a proprietary portfolio-construction algorithm, which uses validated rankings from the stockselection model to create an optimal portfolio. The tool s objective is to optimise the portfolio by selecting the highest ranked stocks with low expected risk and attractive upside potential. It aims to maximise the exposure of the portfolio to the highest ranking stocks. Portfolio turnover is regulated by only selling stocks when they fall into the bottom 40% of the ranking. In the long run this leads to lower transaction costs and higher returns. After the start-up phase Robeco applies a selldriven process to rebalance the portfolio (3). Each month, or in case of cash flow adjustments, the portfolio is rebalanced according to the latest stock ranking. Stocks in the bottom 40% of the ranking are sold and the proceeds used to buy the highest ranked stocks. 16 Low-volatility investing - From theory to practice

17 Robeco Conservative Equity approach Figure 3: Robeco portfolio construction 1) Stock Ranking Client Portfolio 2) Model Portfolio Construction 1) Stock Ranking Qualitative check on stock rankings Qualitative check on corporate actions - Data issues - IPO s - Merger activity - Spin-offs 2) Model Portfolio Construction Proprietary portfolio construction algorithm Optimise portfolio to the highest ranked stocks with low expected risk and attractive upside potential Limit turnover 3) Cash flow or Rebalance 3) Client Portfolio Check portfolio guidelines Continuous monitoring of portfolio: - Cash in/outflow - Position limits - Corporate actions - FX Source: Robeco Low-volatility investing - From theory to practice 17

18 Use of the Conservative strategy in a broader portfolio Use of the Conservative strategy in a broader portfolio Robeco Conservative Equities is designed for clients who are explicitly interested in equity capital preservation, dividend income or diversification within equity markets. Investors should also consider how the strategy fits into a broader portfolio. It can be combined with a high-dividend or benchmark-driven investment strategies and can help to reduce overall portfolio volatility: Combined with high dividend funds A Conservative fund and a high-dividend fund go together well, because they offer a clear diversification benefit when they are combined. The reason is that stocks in both strategies are selected in different ways. Low volatility takes lowrisk as the starting point with a high dividend yield as a by-product, while a high dividend strategy focuses first on dividend yield. Combined with benchmark-driven funds The Conservative Equity strategy can offer diversification benefits when it is combined with a benchmark-driven investment strategy. The Conservative Equity strategy exhibits a different return pattern compared to many traditional equity funds. The strategy focuses on doing better in down markets and has a different return pattern than benchmark-driven funds. Diversification can be realised when both return patterns are combined. 18 Low-volatility investing - From theory to practice

19 Use of the Conservative strategy in a broader portfolio Our ideas on selecting low-volatility stocks Traditional theory states that higher-risk stocks lead to higher returns. However, Robeco research proves that the risk-return relationship in the equity market is flat or even negative. Hence, a portfolio of low-volatility stocks results in better risk-adjusted returns for investors than the market. This low-risk anomaly is exploited by Robeco s highly successful Conservative Equities strategies for: Emerging Conservative Global Conservative European Conservative US Conservative Combined with higher risk funds The total volatility of an equity portfolio can decrease the more you invest in a Conservative fund. And investors can therefore make use of the lower risk this creates to seek out higher risk in other parts of the portfolio. Consider, for instance, investments in small caps or thematic investing. Low-volatility investing - From theory to practice 19

20 Robeco Emerging Conservative Equity Fund - Key features Robeco Emerging Conservative Equity Fund - Key features There are four key features to Robeco s Conservative Equity Emerging Markets strategy that investors should know about. Faster recovery by limiting losses The aim of this strategy is to realise equity returns with substantially lower downside risk. In order to capitalise effectively on the low-risk anomaly, a long-term investment approach is required. The advantage of Robeco s low-volatility strategy is that, in a declining market, the stocks involved typically fall less than other stocks. Once the market recovers, low-volatility stocks have less ground to make up to recover and start yielding positive returns again. This compensates for the fact that the strategy may lag the MSCI Emerging Markets Index in a strong bull market. The main objective of the fund is to achieve a long term full cycle performance equal to, or greater than, the MSCI Index, but with a lower degree of volatility. Absolute risk is part of the strategy Robeco s Conservative approach does not look at relative risk, but at absolute downside risk. Over the period since inception, our Emerging Conservative Equity Fund has had a historical volatility of around 30% lower than that of the reference index, the MSCI Emerging Markets, while the strategy has outperformed the index in terms of market returns 6. For institutional investors, such as pension funds, this lower downside risk is interesting, because it can help to stabilise funding ratios or free up risk budget. 6. Source: Robeco Performance Measurement. Monthly data from March-11 through October-13, gross of fees, based on net asset value of Robeco Emerging Conservative Equities Fund 20 Low-volatility investing - From theory to practice

21 Robeco Emerging Conservative Equity Fund - Key features Not a simple dividend strategy The stocks that Robeco Emerging Conservative has on its radar are not only expected to have a lower risk, but usually deliver a relatively high dividend yield. This is a result of the investment strategy. It does not just focus on selecting the stocks with the highest dividend yields, as in a simple high dividend strategy. The starting point is selecting the most attractive low-risk stocks. This results in a selection of low-risk stocks with a relatively high dividend return. Factors that improve the risk-return profile Stock selection is not only based on volatility, but also on low distress risk and valuation- and momentum-driven factors. This balanced approach distinguishes Robeco from other providers who only focus on historical data. The combination of losing less in down markets and capturing a reasonable rate of return in up markets enables Robeco Emerging Conservative Equity to achieve a long-term full cycle performance equal the MSCI Emerging Markets Index, with a lower level of volatility. The value of your investments may fluctuate. Past results are no guarentee of future performance. Low-volatility investing - From theory to practice 21

22 Investment team Robeco s Low-Volatility strategies are managed by an experienced team of investment professionals within an organisation that is fully committed to quantitative investing. It brings together a portfolio management team and a research team focusing on quantitative research and model development. Michael Strating Head Quantitative Equities Developed Markets Emerging Markets 24 years experience Tim Dröge Portfolio Manager Emerging Markets 15 years experience Pim van Vliet, PhD Portfolio Manager Low Volatility Value & Momentum 14 years experience Arlette van Ditshuizen Portfolio Manager Low Volatility 17 years experience David Blitz, PhD Head Quantitative Equity Research Innovation 19 years experience Joop Huij, PhD Researcher Stock selection models Innovation 12 years experience Bart van der Grient Researcher Portfolio construction Data management 7 years experience Simon Lansdorp, PhD Researcher Stock selection models Portfolio construction 6 years experience 22 Low-volatility investing - From theory to practice

23 Wilma de Groot, CFA Portfolio Manager Emerging Markets Developed Markets 13 years experience Maarten Polfliet, CEFA Portfolio Manager Value Low Volatility 15 years experience Willem Jellema, CFA Portfolio Manager Momentum Low Volatility 13 years experience Mike McCune, CFA Client Portfolio Manager 19 years experience Weili Zhou, CFA Researcher Portfolio construction Stock selection models 12 years experience Frank Wirds Client Portfolio Manager Region focus: Asia-Pacific 8 years experience Jornt Beetstra Researcher Data management 16 years experience Low-volatility investing - From theory to practice 23

24 Fund data Name Robeco Emerging Conservative Equity Fund (AUD) Category Emerging markets equities fund Managers Pim van Vliet and Arlette van Ditshuizen Established October 2013 Tradability Daily Date of inception 14 February 2011 Issue Date 4 October 2013 APIR-code ETL0381AU ARSN-code Highlights Innovator in low-risk investing since 2006 based on award winning research Approach based on the low-risk anomaly Systematic research driven investment approach Aims for long-term equity returns at distinctly lower downside risk than the reference index Enhances diversification given its different risk-return profile Contact Stephen Dennis Managing Director, Australia & New Zealand Tel: s.dennis@robeco.com Brett Penprase Director Tel: b.penprase@robeco.com 24 Low-volatility investing - From theory to practice

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27 Important Information This document is distributed in Australia by Robeco Hong Kong Limited (ARBN ) ( Robeco ) which is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) pursuant to ASIC Class Order 03/1103. Robeco is regulated by the Securities and Futures Commission under the laws of Hong Kong and those laws may differ from Australian laws. This document is distributed only to wholesale clients as that term is defined under the Corporations Act 2001 (Cth). This document is not for distribution or dissemination, directly or indirectly, to any other class of persons. It is being supplied to you solely for your information and may not be reproduced, forwarded to any other person or published, in whole or in part, for any purpose. This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing. This document is intended to provide the reader with information on Robeco s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. The contents of this document are based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Investment involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance. Low-volatility investing - From theory to practice 27

28 Contact Robeco Australia Darling Park Tower 3 Level 16, 201 Sussex Street Sydney NSW 2000 Australia T I