Low Volatility Strategies at Their Core
July 05, 2016
There is a belief among investors that the higher the risk, the higher the return. On the surface, that seems to make sense: if you take on more risk, you should be compensated by more return. That is what is assumed in modern portfolio theory and is based on the belief that markets are efficient and therefore, there are no anomalies. But, the reality is that most markets are not efficient and anomalies do exist. Academic research has shown that over long time periods, investors actually get higher returns from less volatility*. This has become known as the low-volatility anomaly.
Let’s start by defining risk. In equity markets, risk is usually defined by volatility which is generally explained by standard deviation. Standard deviation is used to quantify the amount of variation or dispersion of returns. A low standard deviation means that the returns are close to the average or, in other words, are relatively consistent. A high standard deviation means that the returns are more spread out and are less predictable. The takeaway is that higher standard deviation means higher volatility.
The other factor that we need to understand when discussing volatility and how to reduce it is Beta. Beta is a measure of the volatility of a security or portfolio in comparison to the market as a whole. A low Beta means a stock has less volatility than the general market and a stock with a high Beta has more volatility than the overall market. For example, if your portfolio has a Beta of 1.5 and the market goes up 10%, your portfolio should go up 15%. If your portfolio has a Beta of 0.60 and the market goes up 10%, your portfolio should go up 6%. It is important to note that these are backward looking numbers and they can change going forward but they are generally pretty good indicators of relative volatility.
Finally, we need to remember something that was taught to me early in my investment career. The best way to make money in the long run is to limit the magnitude of portfolio drawdowns or pull backs.
One way to provide downside protection is to buy stocks with less volatility on both an absolute basis (low standard deviation) and on a relative basis (low Beta). To illustrate this, let’s look at calendar years 2008 & 2009 in the Canadian market. In 2008, the S&P/TSX was down 33.0% before rebounding 35.1% in 2009. If you owned the index for those two years, the net result would have been a loss of about 9.5%. If you owned a Canadian Equity portfolio with a Beta of 0.60, your 2008 return would have been down 19.8% followed by a rebound of 21.0% in 2009. This would have resulted in a net loss of only 2.9%. It is important to understand the impact of significant portfolio losses and the benefit of limiting them. Protecting your investments by losing less should lead to greater longterm wealth accumulation.
Since 2008, investors have become more concerned with portfolio volatility and have therefore been reluctant to invest in equities or have been quick to “go to cash” at the first sign of trouble. Unfortunately, being reactionary has caused investors to buy at the wrong time and sell at the wrong time or, in other words, buy high and sell low. While I believe that invest should be somewhat active in their portfolio exposure to risky assets, I also believe that investors need to have a solid Core group of long-term equity holdings that they just buy and forget about. That is particularly true in the current low interest rate environment where there are limited places to invest that still have the potential for growth.
As investors get older, they may not have the investment time horizon needed to recover from market pull backs before they need to access their lifelong savings. Unfortunately, those same investors may also need growth to allow them to continue to live a similar lifestyle when they do start to draw on those savings. To satisfy this need for more protected equity growth, low volatility or “low vol” funds are being introduced. This type of fund is designed to provide equity upside, although likely not to the same extent, with better downside protection for the inevitable weak years in the market. They are different from absolute return funds in that they will usually track the market direction but not to the same magnitude (positive and negative). Owning low vol funds will allow investors to comfortably stay invested in equities when they would have exited in the past due to greater downside protection. Staying invested should help reduce the negative outcome generally associated with trying to time the market.
Of course, the next logical question is what does a low vol fund look like? First and foremost, low vol funds tend to own stocks with lower Betas and thus lower volatility. Low Beta stocks tend to have more predictable and recurring earnings, more consistent growth from year to year, high returns on equity, a history of increasing dividends or share buybacks, and high cash flow yields, to name a few characteristics. In other words, low vol funds tend to be filled with boring, non-headline news type stocks that quietly provide solid returns. Some familiar Canadian examples are BCE, Dollarama, Loblaw Companies, Atco, Sun Life, Royal Bank and Gildan Activewear. While high dividends are not a requirement, many of these companies generate enough free cash flow to pay out a meaningful dividend.
Companies with the above traits are more prevalent in certain sectors or sub-sectors of the market. As a result, low vol funds tend to be overweight sectors such as consumer staples, utilities, telecommunications and health care (in the U.S.) and underweight cyclical sectors such as energy and basic materials. For example, Canadian large cap energy producers have an average three year Beta of 1.7 and Canadian large cap gold companies have an average three year Beta of 2.3. To put that in perspective the average three year Betas are 0.3 and 0.2 for Canadian large cap utilities and staples, respectively. Owning these lower volatility stocks will likely smooth the market’s violent upward and downward swings but still be correlated to market direction. They will usually underperform in strong bull markets and outperform in bear markets but probably lead to the same, if not greater, long-term results with a smoother ride.
When constructing a low vol portfolio, the question becomes do you own the lowest volatility stocks in each sector or do you avoid the sectors with extreme volatility? If you own the lowest Beta stocks in each sector then you will track the index better but you will bring more downside risk to your portfolio.
Personally, I believe that you should attempt to avoid high Beta stocks in a low vol strategy, even if that means having little to no exposure in certain sectors.
Who should own low vol funds? Volatility becomes moreconcerning as you get older since the time horizon until you need to access the money is shorter giving less time for a recovery after a market pull back. Having said that, it is also a concern if you have a planned use of proceeds such as paying for a wedding, buying a house, or paying for school. Finally, many investors are conservative or nervous so they are willing to sacrifice some upside for better downside protection. As a result, low vol funds (Canadian and Global) are an integral part of long-term investing for all ages and should make up the Core buy and hold part of any well thought out portfolio.
Low Vol Funds and the Canadian Market
The low-volatility anomaly is based on the belief that markets are not efficient, which I believe is the case in Canada. As an example, let’s go back to the beginning of 2003 and see how the Canadian market has done as a whole and how it has done if you excluded direct exposure to the cyclical, high Beta commodity sub-sectors (energy and mining).
The no commodity TSX represents a buy and hold portfolio (with reinvested dividends) containing the S&P/TSX TRI, less the Capped Energy and Capped Mining sub-indices. The weights within this portfolio are based on the S&P/TSX sector weights at inception. ^ as of May 31, 2016.
Looking at the year-by-year data, two things stick out immediately. First of all, all three times the S&P/TSX posted a negative return, it would have been better to not own commodities. Secondly, the no commodity TSX has outperformed each year from 2011 – 2015 after underperforming seven of the previous eight years.
Looking at the data plotted on a line graph, the no commodity TSX actually delivers a better return with significantly less volatility than the overall S&P/TSX TRI since the beginning of 2003.
Given the above information, it is surprising that there are not more low vol funds available to Canadian investors but, I guess, much like the stocks they own, they are boring. Over the next few years, I believe that more and more low vol funds will be introduced to Canadian investors as aging investors’ risk tolerances change and market uncertainty makes investors realize they need a disciplined, long-term, conservative equity portion in their portfolio.
In conclusion, low volatility investing is the style of the future but also the present. For investors of all ages, it has become more important to add a conservative Core part to your portfolio that you buy and hold with a long-term view. While it may not be your entire portfolio, it should be an integral part of helping you meet your long-term investment goals. In order to generate performance and to diversify, there is certainly a spot for stocks and funds with more volatility but too many investors have not embraced low vol investing yet. The time is now. Add a low vol component to your portfolio.
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Keith LeslieChief Risk Officer & Portfolio Manager
Keith Leslie is the Chief Risk Officer (CRO) and a Portfolio Manager at Norrep Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and…
Keith Leslie CFA
Chief Risk Officer & Portfolio Manager
- ExpertiseQuantitative Investing
Keith Leslie is the Chief Risk Officer (CRO) and a Portfolio Manager at Norrep Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award winning Portfolio Manager. Prior to joining Norrep in 2001, Keith worked as a Quantitative Analyst at a western Canadian investment firm.
Keith brings a different perspective to the firm’s investment process, using statistical techniques, valuations tools and modeling. He is the Portfolio Manager of Norrep Market Neutral Income Fund, Norrep Canadian Enhanced Equity Fund and Norrep Core Canadian.
Keith graduated from Western University with a Bachelor of Science in Statistics and Mathematics and is a CFA charterholder.
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