Beware low-volatility stock allocation or face potentially
significant underperformance in the years ahead, experts have
The warning comes amid increasing concerns that traditional
defensive equity strategies which surged in popularity
after the financial crisis are vulnerable to
underappreciated risks from monetary policy, interest rates,
factor tilts, and geopolitics.
Speaking at the
EDHEC Risk Institutes Smart Beta Day in London, Dr.
Eric Shirbini, a director at ERI Scientific Beta,
warned that use of traditional defensive portfolio modeling
could risk sub-standard returns.
Shirbini argued that traditional defensive strategies are
heavily biased to the low-volatility factor by their very
construction, and therefore miss out on rewards from other
factor tilts when market sentiment shifts.
Investing in low-volatility stocks is great when there
is a downturn in the market as you tend to outperform, but when
the market goes up, these low volatility strategies tend to lag
behind, he said. Low risk, low-volatility
strategies tend to be much more sensitive to changes in
interest rates... you end up taking a lot of country risk,
which is not well-rewarded and these strategies can be
very concentrated in certain sectors as well.
Shirbinis warning follows recent cautionary notes from
asset managers that sophisticated investors need to look again
at how they calculate risk.
In an interview with Institutional Investor, Erik Knutzen
chief investment officer of multi-asset class strategies
Berman said risk has more complexity than it ever
The promise and premise of low-volatility equity
portfolios is for structural and behavioural reasons, he
says. It appears, historically, that investors in low
volatility have been rewarded more, per unit of risk, than what
capital market theory indicates they should.
Knutzen adds he believes a reasonable expectation for
a low-volatility stock portfolio would be a lower return
than the broader market, but with a higher Sharpe ratio.
The downside of these low-volatility equity strategies is
that they do have biases. They have weightings towards sectors,
stocks with higher income levels, cap weighting, etc. What you
experience with any of these risk factors are performance
cycles. In our view, we dont view low volatility as a
standalone risk factor. We dont believe that it is
Knutzen says it is important to understand the implicit
risks associated with defensive positioning, citing last
years rotation from defensives into value stocks as an
example of underappreciated risks. In the case of the
value factor, we think investors are writing you cheques for
owning value stocks because you are taking on additional
default risk. [Investors should] identify factors that are
independent and discreet.
Just a few weeks ago, Eoin Murray, head of investment at UK
investment house Hermes, warned of several
flashpoints in a paper to investors.
We believe that traditional methods of portfolio
diversification that rely principally upon historical measures
of correlation will be less effective in 2017 and beyond,
he wrote. This is because the potential for regime change
in cross-asset correlations remains as great as it has been in
recent times. The majority of our volatility measures continue
to point to a low-risk environment but we believe that
they could be masking some fragility, and for that reason
anticipate some turbulence in 2017.
Murray isnt alone. Speaking at this weeks London
conference, Tomas Franzen founder of Franzen Advisory
said market conditions are now changing, demanding a
reconsideration of defensive strategies. The tide of
super easy monetary policy is probably over,
he said. I had thought that was the case a few years ago,
but now we are starting [to see] what will happen to our
different strategies and our asset class exposures as bond and
gilt rates are not moving downwards any longer.