Beware low-volatility stock allocation or face potentially significant underperformance in the years ahead, experts have warned.
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 Institute’s 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.”
Shirbini’s 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 at Neuberger Berman – said risk has more complexity than it ever has historically.
“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 don’t view low volatility as a standalone risk factor. We don’t believe that it is consistent.”
Knutzen says it is important to understand the implicit risks associated with defensive positioning, citing last year’s 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 isn’t alone. Speaking at this week’s 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.”
