Timing is good for a low-volatility strategy

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Low-volatility stocks are trading at their lowest valuations since the end of the global financial crisis, says Leonie MacCann, senior multi-asset portfolio manager with Irish Life Investment Managers.

She said the timing couldn’t be better to invest in low- to mid-volatility stocks — a class of equities that consistently delivers higher returns than its high-volatility counterpart.

“It’s commonly held that the higher-risk investment should deliver a higher return,” she said. “But actually, when you look at the empirical evidence in global equity markets, the opposite is true.”

The difference is even starker when returns are calculated on a risk-adjusted basis, she said. This so-called low-volatility anomaly stems from the fact that low-risk companies are in shorter demand as investors focus on short-term goals and try to outperform quickly. Low-volatility equities are deemed too sluggish and tend to be undervalued.

“Investors would typically overpay for attention-grabbing, high-volatility companies, names they see in the press, high-growth companies where they think there’s a potential for a lottery-like payout,” she said. “They’re trying to get a big bet, a big win.”

This kind of thinking led to wild overvaluation of “meme stocks” like Texas-based GameStop Corp., and Kansas-based AMC Entertainment earlier this year.

Institutional investors would be well advised to base their picks on more than simply company size, she said.

“You can get a risk-return enhancement by looking at both factor and stock-specific risk diversification in your portfolio, rather than just allocating capital based on the company size,” she said.

She acknowledged that last year was not a shining moment for low-vol strategies. Although low-volatility equities provided some protection during the sell-off in early 2020, they dramatically underperformed during the subsequent rally, when tech stocks and consumer cyclicals shone.

“The type of companies that did well last year were those companies that benefited from the stay-at-home momentum,” she said. “And these are exactly the opposite of the type of companies that low-volatility and minimum-volatility strategies invest in.”

Active management

MacCann insisted that while low-volatility equities have a long track record of outperforming their higher-risk counterparts, a low-vol strategy is incomplete without active management.

“Most investment portfolios are generally allocating capital based on company size,” she said. “This actually leaves considerable scope for a risk-return enhancement.”

MacCann said investment managers would be wise to consider both factor and stock-specific risk diversification in their portfolios, rather than just allocating capital based on the company size.

“There’s a real opportunity for actively managed strategies to generate better risk-adjusted returns by allocating and investing into low-risk, stable and profitable companies while avoiding higher-risk, higher-growth companies.”

She said low-volatility strategies face three main risks — all of which can be reduced with active management.

Interest-rate sensitivity, valuation risk and concentration risk are common pitfalls in low-volatility strategies. The solution includes taking a multi-factoral approach to investing, she said.

“A single-factor approach would just use volatility on a stand-alone basis, so purely look at companies and assess them on volatility and just invest or overweight in the lower-volatility stocks,” she said. “A multi-factor approach doesn’t just look at volatility alone but also considers company fundamentals.”

She recommended investors consider things like valuation, quality and leverage to ensure appropriate levels of diversification.

“That is a good way to avoid those pitfalls,” she said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.