Take a look at the business section next time you’re in a bookshop and the chances are the smiling, bespectacled face of Warren Buffett will be looking at you from multiple book covers, advocating the merits of value investing.
It is not quite the same with low-volatility strategies.
Although low-volatility investment strategies have steadily gained popularity among institutional investors worldwide in recent years, there are no ukulele-playing sages who have made this form of investing a key topic in the popular investment genre.
Pim van Vliet, Managing Director of Conservative Equities at Robeco, thought it was time to change this and has published a book that explains the history, methodology and application of the low-volatility anomaly in simple terms.
Although written in a popular style, Van Vliet doesn’t avoid dealing with some of the more contentious issues around this style of investing.
Early on, he addresses one of the key concerns of the more cynical investor in the industry: why hasn’t this anomaly been more widely researched before?
Part of the reason is found in the way academic research is done, in particular the time frame over which strategies are measured.
To get a statistically significant sample, a researcher has to take many datapoints and this often means short investment horizons. Typically, researchers take a month as the average time horizon.
But this means they largely strip out the effects of compounding returns, Van Vliet says.
“In my own research, if I had used five-year returns over 50 years of data, then you have 10 observations and then all your statistical tests are powerless,” he says in an interview with [i3] Insights.
“You need more observations and to do that you cut your sample into smaller pieces to get more significance, but to do that you also assume a shorter period.
“In most cases, it is not an issue. However, if you compare strategies on risk, where the higher the volatility the lower the compounded return, then it gets distorted.”
For most research into value or momentum strategies, short time horizons are not so much of a problem, but for identifying the benefits of low-volatility strategies, you have to know where to look.
Van Vliet credits the late Robert Haugen, a United States financial economist and pioneer in quantitative investing, as the first person to know where to look.
Van Vliet credits the late Robert Haugen, a United States financial economist and pioneer in quantitative investing, as the first person to know where to look.
In the 1970s, Haugen experimented with the compounded returns of low-volatility versus high-volatility portfolios and found low-volatility stocks consistently outperformed the market.
Too Popular for its own Good?
One of the key concerns today is whether low-volatility strategies are getting overcrowded or will become victims of their own popularity, resulting in the anomaly being eroded away.
Van Vliet argues neither will be the case, partly due to the nature of the investment industry.
Most asset managers focus on relative risk, which often means time horizons are short, compounding is ignored and the chances of not keeping up with dramatic bull markets make this strategy somewhat unappealing for many fund managers.
In short, high-volatility stocks offer a better chance of short–term outperformance.
Unless the investment industry does away with relative performance and adopts risk-based benchmarks, the low-volatility anomaly is unlikely to go away anytime soon, Van Vliet writes.
“From the relative risk perspective of investment professionals managing their career, it makes perfect sense to pass up the opportunity of investing in a low-risk investment strategy.”
In a more recent paper, Van Vliet’s colleague, David Blitz, Head of Quantitative Equities Research at Robeco, also shows hedge funds are often on the other side of the low-volatility trade, buying up largely high–volatility stocks, thereby balancing out the inflows into low-volatility strategies.
Mixing it Up
In Robeco’s approach to low-volatility investing it advocates a method that doesn’t pursue a single factor by itself, but blends its low-volatility method with income and momentum factors to get a more efficient exposure.
Yet, many investors are wondering whether it would be possible to take a more dynamic approach to factor investing and ‘time’ allocations to individual factors.
“That is of course the holy grail in quant investing. For generic factors we do see some evidence that if low vol is very cheap, the following, long–term returns are somewhat higher. There is some weak evidence for that,” he says.
“But if you integrate factors like value and momentum into a multi-factor low-vol strategy, this timing element goes away. You cannot time it anymore.
“But for generic factors there is a little bit [of evidence]. For example, if momentum is very expensive, then there is some predictive power, just a little bit. So yes, you can do it a little bit, but it doesn’t make you rich.”
Fixed Income
For investment strategists who embrace factor investing it makes sense to look at a way to incorporate this model into the portfolio overall, across all asset classes.
But outside of equities, factor investing is still relatively new.
Van Vliet admits it becomes more difficult in asset classes that are less liquid and have fewer securities to trade in, and this leads to greater tracking error.
“We have been successful in exploiting the low-vol factor in corporate bonds for five years, but we offer this only to institutional clients. It is more difficult, but the risk reduction is even higher, so you really move to the left in the risk/return space,” he says.
“You need breadth there, so for government bonds you have less countries [than you have companies on the credit side of the spectrum].
“[The anomaly] is also present in private equity and alternatives, but not to the same extent as you see it in equities and corporate bonds.”
Sharing Insights
Although Van Vliet keeps his explanations simple and free from complex formulas, he shares quite a few insights with his readers. He even gives them a method for creating their own 100–stock portfolio with the help of the Google Stock Screener and narrowing it using income and momentum factors.
Asked if he doesn’t give a little too much away by showing how to implement a basic low–vol portfolio, he responds somewhat philosophically that asset managers in the current day and age are more like services providers rather than the keepers of closely guarded secrets.
“We live in the 21st century where information is abundant, so no, I’m not afraid [of disclosing sensitive information]. We show about 80 per cent of how it can be done in a very simple way,”he says.
“Sometimes people ask the question: ‘Active management, is it worth the fees?’ Well, it is like a service. You can see in this example that there are 100 stocks and they all have corporate actions and that is just a simple example.”
High Returns From Low Risk: A Remarkable Stock Market Paradox
By Pim van Vliet and Jan de Koning
164 pp. John Wiley & Sons Inc.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.