Why nimble low volatility strategy is 'here to stay'

Portfolio manager on approach that lifts constraints on sector weighting

Why nimble low volatility strategy is 'here to stay'

On the face of it there seems no better time to seek less volatility in your portfolio. Life is always uncertain but that feeling is certainly heightened right now. Not only do we have a bitter U.S. election battle but the pandemic second wave is claiming scores of victims and putting more pressure on economies.

Low volatility investing is nothing new, of course, and Mike Clare, vice president and portfolio manager at Brompton Funds, told WP it’s a phenomenon that’s been around for 90 years. Brompton launched its Brompton North American Low Volatility Dividend ETF towards the end of April this year – and he said its active strategy provides extra flexibility at sector level.

There are essentially two ways to use a low volatility strategy. The first is to simply construct a portfolio of the lowest volatility stocks by taking, for example, the 100 least volatile from the S&P 500 Low Volatility Index. Investors can also use an optimization software approach to reduce volatility at the portfolio level. By using the MSCI USA Minimum Volatility Index or Canadian Minimum Volatility Index, this examines not only security volatilities but also cross correlations. For example, you might end up with a few securities in there that have higher volatility but because they are less correlated to the rest of the universe, it actually reduces volatility. Gold is a good example of this.

Clare explained that while these strategies typically do well, they'll often be constrained at the sector level, meaning each sector weight might only be plus or minus 5% versus the underlying index. Brompton uses the portfolio level volatility approach, with optimization software, but it does not constrain itself at sector level.

He said: “We have the flexibility to take higher weightings in something like consumer staples, which is a relatively low weight in the overall market. We’re not constraining ourselves to be within plus or minus 5% of that weight.

“In our portfolio, we've actually been approximately 50% invested in consumer staples because we think that's one of the lowest volatility sectors, and it really helps reduce portfolio-level volatility.”

This ability to be nimble is also beneficial when looking at utilities and real estate. Traditionally low volatility sectors, they don’t move as much as the rest of the markets. However, this year that volatility has been ramped up and they were actually riskier. When the fund launched, it had no exposure to utilities or real estate but that’s now changed.

Clare said: “We’ve all heard the phrase that during a correction, correlations all go down to one. Well, that’s essentially what happened with utilities and real estate. Since then, utilities are trending back towards more of a historical level, so we've started to add some.”

Consumers staples, meanwhile, were a relative outperformer in March and have largely remained so through 2020. The fund has, therefore, kept its high weighting.

As the political and health situation continues to disrupt the world, low volatility appears an oasis in the storm. But Clare stressed that headline news is not the sole reason for embracing this strategy. It’s actually an approach that has worked for decades and, compared to the likes of size and valuation, is one of the most consistent factors out there. The reason it has endured? Investor behaviour.

He said: “Investors tend to chase big payoffs by taking outsized risks. I remember prior to 2008 when you had investors chasing small-cap energy and mining stocks. Then more recently, it's been cannabis or cryptocurrency and then even more recently it’s been the Teslas of the world.

“This actually bids the price up of these high volatility assets relative to the plain vanilla boring, low volatility ones. Ultimately, the low volatility stocks and low volatility strategies tend to become systematically under-priced by the market.”

The other theory as to why low-vol strategies have stood the test of time is because of structural impediments in the market. Finance theory is based on certain assumptions, like all market participants can lend and borrow unlimited amounts at a risk-free rate of interest. In reality, that's not true. The theory suggests that if you want to generate outsized returns you should buy a broad market index, and then just use debt or margin to leverage that up.

Clare said: “The reality is a lot of investors can't or won't do that and are afraid of using debt. Or you may get certain types of institutional investors like mutual funds and pension funds that just aren't able to use margin or leverage because of the nature of the regulations around those types of investment mandates.

“So, they will tend to chase these high beta assets in order to generate outsized returns because there they aren't able to do so by using leverage.”

Investor behaviour and structural characteristics are not going away. Clare added: “Investors will ask the question, how long can low-vol strategies continue? I would point to [those elements] and say, ‘we think the low volatility effect is here to stay’.”