Low Volatility Investing: A Consultant s Perspective

Transcription

1 Daniel R. Dynan, CFA, CAIA M E K E T A I N V E S T M E N T G R O U P 100 LOWDER BROOK DRIVE SUITE 1100 WESTWOOD MA fax M:\MARKETING\Conferences & Speeches\CONFERENCES\2013\SD CFA Low Vol\SD CFA Low Volatility Presentation.Docx

2 Agenda Has Low Volatility Worked In the Past? Will the Low Volatility Anomaly Persist in the Future? Why Implement Low Volatility? Peer Universe Performance Comparison What is an Appropriate Allocation for a Long-Term Investor? Potential Risks 1

3 Has Low Volatility Worked In the Past? The Greatest Anomaly in Finance: Low volatility stocks have outperformed high volatility stocks. 16% 14% Low High Volatility Stability Annualized Return 12% 10% 8% High Volatility ] Low Stability 6% 4% Beta Source: SSgA; Deciles are composed of equal-weighted Russell 3000 stocks as broken down by beta from December 1986 to October

4 Let s consider why it may have worked in the past. Will the Low Volatility Anomaly Persist in the Future? The Lottery Ticket effect: individual investors looking for the windfall Benchmark constraints: institutional investors looking to beat the benchmark Low volatility increases tracking error and can actually be a headwind Arbitrage constraints: highly volatile stocks can be expensive and risky to short Implicit Leverage Effect: investors that get explicit leverage buy high beta or high volatility stocks instead It is possible that many of these investor behaviors will persist. While we do not necessarily believe that low volatility stocks will continue to outperform the market with less risk, we do think they should produce market returns with less risk (attractive risk-adjusted returns). And we are excited to accept that! 3

5 On a Standalone Basis: Downside Protection Why Implement Low Volatility? The winning by not losing approach. Compounding returns can be powerful. Attractive risk-adjusted returns Many of the low volatility indices have produced attractive absolute and risk-adjusted performance historically, and have protected capital well during down markets. In a Total Portfolio Context: Reduce equity risk without sacrificing return. Lowering equity volatility reduces total portfolio risk. Increase return without adding risk. The risk budget to be spent elsewhere in potentially higher returning asset classes. For example, emerging markets, small cap, hedge funds, or private equity. An alternative to the traditional capitalization-weighted benchmarks. Capitalization-weighted benchmarks can be overexposed to certain high-risk sectors or stocks during market bubbles. A cost-effective alternative to hedge funds. 4

6 Index Universe Summary S&P Low Volatility Index MSCI Minimum Volatility MSCI High Dividend Yield Russell Dividend Achievers QSI Index Russell Defensive Indexes RAFI US Low Volatility S&P High Quality S&P High Yield Dividend Aristocrats PowerShares S&P 500 Low Volatility STOXX Select Dividend Indexes STOXX Maximum Dividend Indexes Northern Trust Quality Low Volatility Russell Low Volatility Indexes ishares Dow Jones Select Dividend ishares High Dividend Equity PowerShares Dividend Achievers PowerShares High Yield Dividend Achievers Vanguard Dividend Appreciation Vanguard High Dividend Yield CBOE Low Volatility Index Morningstar Dividend Yield Focus Index Russell Volatility Control Indexes S&P Low Volatility Risk Control Indexes S&P 500 Dividend Aristocrats Northern Trust Quality Dividend Focus In recent years, there has been a proliferation of alternative beta indices, seeking to achieve superior risk-adjusted returns by capturing the low volatility, high quality, and/or dividend paying stock universes. 5

7 Common Period: Peer Universe Performance Comparison 1 As of December 31, 2012 Russell 3000 Defensive S&P Low Volatility Russell 3000 Index Trailing Return 4.4% 7.4% 4.1% Standard Deviation Information Ratio NA Sharpe Ratio Tracking Error 5.1% 8.8% NA Beta Correlation with Bench. 97% 87% 100% Upside Capture 74% 50% NA Downside Capture 76% 62% NA On average, two popular low volatility indexes have produced attractive absolute and risk-adjusted performance. Historically, the indexes had exhibited low volatility and beta, and have protected capital well during down markets compared to the Russell 3000 Index. 1 Index performance is shown gross of fees from August 1, 2001 through December 31,

8 Potentially Significant Tracking Error Potential Risks Historical tracking errors have been 4% to 9% versus the capitalization-weighted benchmarks. As all low volatility indices take an active risk in defensive factors, short-term relative performance can be extreme. Some strategies can lag up to 20% in a rapidly rising market. Industry concentration Many popular indexes tend to be significantly overweight to consumer staples and utility stocks The S&P Low Volatility has 58% invested in utilities and staples (28% and 18% active weights), respectively. Large Cap Capitalization bias Many popular indexes tend to be significantly invested in large cap stocks Value Bias Stock concentration No guarantee of long-term outperformance. Investing in low volatility equities (and other alternative beta equity strategies) requires a long-term time horizon. 7

9 What is an Appropriate Allocation for a Long-Term Investor? It depends on the goals of the allocation and the strategy employed. We consider low volatility in the realm of non-capitalization weighted strategies, which also includes high quality, fundamental-weighted, equal-weighted, risk-weighted, among other strategies. 25% to 50% of domestic equities to non-capitalization weighted strategies may be reasonable. Hypothetical Risk/Return Analysis 1, 2 Portfolio Allocations Hypothetical Portfolio Expected Average Annual Return Expected/ Historical Standard Deviation Sharpe Ratio 60% Equities / 40% Bonds 6.8% 11.1% % Eq. / 15% Low Vol. Eq. / 40% Bonds 6.8% 10.2% 0.67 Risk-Equivalent Alloc. (55% Eq./45% Bonds) 6.5% 10.2% % Eq./15% LV/5% EM Eq./35% Bonds 7.1% 11.1% 0.65 A low volatility allocation may improve the efficiency of an equity portfolio. The risk-equivalent portfolio would have a 30 basis point reduction in expected returns. Redeploying the risk budget to EM equities could add 30 basis points in expected returns. 1 Assumes market expected equity returns (9.3%), with an elevated historical standard deviation (13.0%) and actual average correlation (0.88) of two popular low volatility strategies. 2 Based on Meketa Investment Group s 2013 Asset Study. 8