Welcome to Soundbites – weekly insights on market trends, and investment strategies, brought to you by Investment Executive, and powered by Canada Life.

For today’s soundbites, we speak about low-volatility strategies with Leonie MacCann, senior multi-asset portfolio manager with Irish Life Investment Managers. We talked about whether now is a good entry point for low-volatility investing, the low-volatility anomaly, and why 2020 returns may have been lower than expected.

Leonie MacCann (LM): When the Covid pandemic kicked off, markets got spooked, we saw a huge spike in volatility, and markets sold off. When you saw that sell off in Q1, low-volatility strategies did provide downside protection. They did outperform broader global equity markets by about 3.6% or 3.7%. But then, as markets rallied, they failed to keep up with that rally. So, why did they underperform versus broader markets? Well, you need to look at the type of stocks that did well during that period. These were companies that typically have a higher level of idiosyncratic risk and were higher beta. And these are exactly the opposite of the type of companies that low-volatility and minimum-volatility strategies invest in.

Whether the current moment is a good entry point for low-vol investing.

LM: In the wake of the pandemic and the rally we saw last year, with low volatility underperforming, low-volatility stocks are now trading at their lowest valuations since the end of the global financial crisis. So, this does suggest that now is a much better entry point for this style of investing than we’ve seen in recent history. That gap has narrowed somewhat, but it’s still very much an attractive entry point.

The so-called “low-volatility anomaly.”

LM: It’s commonly held that the higher-risk investment should deliver a higher return. But actually, when you look at the empirical evidence in global equity markets, the opposite is true. And furthermore, if you look at it from a risk-adjusted basis, that distinction actually becomes even more delineated. And this is what is known as the low-volatility anomaly. There’s a couple of reasons for this. The first is that there tends to be lower systematic demand for lower-risk companies. So, as a result, lower-volatility companies tend to get mispriced and undervalued. And the reason for that lower demand is often really just about short-term incentivism. The second reason is a bit more behavioral in nature, and this is the idea that investors would typically overpay for attention-grabbing, high-volatility companies, names they see in the press where they think there’s a potential for a lottery-like payout. So, they’re trying to get a big bet, a big win. And then the third reason for it really lies more at the portfolio level, where they’ve generally allocated their capital based on a company’s size. There’s a real opportunity for actively managed strategies to generate better risk-adjusted returns by investing into these low-risk, stable, and profitable companies.

The pitfalls of low-vol strategies.

LM: There’s really three main risks with low-volatility strategies. And the first is that low-volatility stocks may be more interest-rate sensitive than the broader market. And empirical data would suggest that that is the case. The second risk is valuation risk. You could end up investing in companies that have excessive valuations. And then the third is that you could end up having concentrated bets in certain market segments or companies. However, there are ways of mitigating these risks and an actively managed approach is one way to mitigate them. So, a look at things like valuation, quality, and leverage factors of a company, rather than just focusing on statistical risks and thereby ensuring that you have appropriate levels of diversification, so that you avoid any overcrowding or concentration.

And finally, what’s the key takeaway?

LM: I think the key takeaway really is that the investment rationale for low volatility is very much intact. We’ve seen this style of investing historically underperform in comparable market environments. But importantly, there is very much clear evidence of a low-volatility anomaly, and the returns from a low-volatility strategy wasn’t significantly different from equivalent passive global equity strategy, despite delivering significantly lower risk. So, you were getting a much better risk-adjusted return. So, the lower-volatility effect has really been proven to be both persistent and resilient.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Leonie MacCann of Irish Life Investment Managers.

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