Low-volatility investing is based on the now widely accepted notion that higher risk does not necessarily translate into higher returns. In a risk-averse world, low-volatility or “low beta” strategies have grown so popular in recent years that some now fear a crowded trade.
In a new whitepaper, Michael Fraikin (pictured), Global Head of Research, Invesco Quantitative Strategies, and Dr Henning Stein, Global Head of Thought Leadership Invesco Fellow at the University of Cambridge Judge Business School, believe that these fears are, as yet, unfounded. They argue that contrarianism has a vital role to play in exploiting the low-volatility anomaly in a mass-market scenario and make the case for low-volatility products that adopt a truly distinctive approach.
“Such strategies should take the best elements of the methodologies now commonplace in the sector – foremost among them the use of factors to exploit the low-volatility anomaly – and combine them with a systematic investment process that draws on experience, expertise and insight,” says Fraikin. The ultimate goal of such an approach should be to recognise the blurring of the lines between passive and active management and to span them as effectively as possible. “We suggest that what investors in this sphere increasingly want is a rigorous, proactive investment ethos that genuinely strives to deliver both low volatility and high alpha.”
The new Invesco whitepaper investigates the theoretical and behavioural underpinnings of low-volatility investing and the extent of their present-day relevance, examines whether the current market is overcrowded and assesses the threats and opportunities that have emerged from the sector’s extraordinary growth. The authors look at the importance of staying ahead of the curve; discuss the construction of portfolios that aim to minimise rather than spread risk; reflect on the role of factors, fundamentals and behavioural insights in achieving this goal; and present evidence of the effectiveness of such strategies.
The notion that greater reward need not involve greater risk is today so widely accepted that “smart beta” funds designed to exploit this anomaly reportedly accounted for more than USD640 billion in assets under management by the end of Q3 2017 (source: ETFGI). Nonetheless, Fraikin and Stein believe that a low-volatility approach still has appeal in a risk-averse age, especially for investors who recognise the continued value of looking beyond the herd.
The philosophy they advocate is one that takes the best elements of the approaches now widespread in this sector – chief among them the use of factors to exploit the low-volatility anomaly – and combines them with a systematic stock-selection process based on experience, expertise and insight. The idea is to construct a multi-factor, low volatility portfolio representing a combination of stocks that will ideally result in a level of portfolio risk noticeably below the market and an exposure to momentum quality and value above the market. On a continuum stretching from “pure passive” to “pure active” they place their preferred style of low-volatility investing somewhere near the middle, favouring the use of multi-factor models combined with rigorous analysis, behavioural insights and active management.
“Applying a bottom-up process to low-volatility investments means looking for stocks whose positive attributes extend beyond comparative immunity to violent ups and downs,” explains Stein. It might be useful, for example, to also consider a company’s earnings expectations, its management, its use of resources and cash flow, its inherent quality and its sustainability as well as current market sentiment.
The goal should be to assemble a portfolio that is shaped by systematic factors and proven concepts alike and which consists of ‘best ideas’ that suggest both stability and attractive fundamentals – or low volatility and high alpha. “With so many funds content to hug their chosen indexes, a meticulous and flexible stock-picking philosophy should lead to investment positions that are not only ‘active’ relative to the benchmark but removed from the humdrum of the average minimum-variance portfolio,” Stein says.
Fraikin and Stein emphasise the need for systematic stock selection to “rise above the mediocrity of the herd” in a world where low-volatility investing has become a mass-market phenomenon. “Low-volatility investing may well have become a bandwagon, but we would argue – for now at least – that any concerns about creaking axles can be most effectively offset by a wise choice of driver. All things considered, there should be some distance to travel yet,” Fraikin concludes.
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