Thursday, June 20, 2019

Low volatility / Low beta performance - This smart beta edge has been real

Investors are currently in a constant search for defensive investments that can generate strong returns similar to equity benchmarks and provide protection if there is a negative equity environment. Most investment choices cannot provide both. Uncorrelated assets by their nature cannot have the same profile as equity benchmarks, so investors have often focused on choices that will give some downside protection but will have good performance tracking with benchmarks.  

The idea of holding low volatility/low beta portfolios has been a defensive choice that has attracted significantly flows and investor attention. The idea is based on an anomaly that low volatility/beta portfolios actually generate higher returns than higher beta portfolios. Higher risk is not compensated with higher returns. This does sound like a free lunch for investors. 

There are a number of arguments for why low volatility portfolios may outperform higher risk portfolios. It is based on the structural idea that investors either do not use or cannot obtain leverage and thus bid up prices for riskier assets. 

Some researchers suggest that this is not a unique factor and the low volatility anomaly could easily be an issue of mispricing. A mispricing issue means that as more money flows into these strategies there will be less opportunity for gain. If the low volatility is related to other factors, then investors are just not getting what they thought. Ongoing research is still needed on this topic but the empirical results are consistent. Low volatility or minimum volatility portfolios do better than their established benchmarks across, time, geography, and sectors. It does not work all of the time but the low volatility does add value during turbulent equity periods. 

A review of some of the leading smart beta low volatility/beta ETFs by size shows that it has been a reasonable strategy that has done well when equity markets have sold-off as well as performing well through time and across different asset class types. The value of low volatility exposure should not be dismissed as a fad.

Low volatility coupled with lower correlated defensive strategies may form a nice combination of choices for investors. A combination of low volatility with managed futures, for example, will allow for close performance with benchmarks in up markets and more protection in down markets. We will show this impact in future blog posts.

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