Aon Hewitt Consulting | Investment Consulting Practice

Factor Investing: What’s the big deal with low volatility equities? September 2016

Risk. Reinsurance. Human Resources.

Table of contents Summary and actions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Factor investing and low volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Low volatility equity performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Going against investment theory – does a low volatility premium exist and, if so, why?. . . . . . . . . . . . . . . . . 7 How to invest in the low volatility factor. . . . . . . . . . . . . . . . . . . . . . . . . . 8 Current risks in minimum volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 The outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

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Factor Investing: What’s the big deal with low volatility equities?

Summary and actions •

•

This paper forms part of a wider Aon research project

•

volatility equity portfolio, whether this is through a

important factors identified in the academic literature.

passive index or an actively managed fund, can benefit

The project will consider how best to access and

portfolios in terms of risk adjusted returns and risk

combine factors initially within equity portfolios and

reduction. For the latter, it is best to select an index with

subsequently across asset classes.

the lowest possible variance or beta. Active management is our preferred option but we recognise that clients

Low volatility investing has generated superior risk

can be constrained or choose not to go down this path.

adjusted returns over the long term. It goes against

In these cases, a passive index would create a broadly

standard market theory that more risk is rewarded

similar, but imperfect exposure.

with more return. Behavioural biases, rebalancing effects and investor constraints are common explanations for the low volatility premium. •

But performance is cyclical and periods of underperformance can be long. This can make things uncomfortable for investors.

•

That said, we believe that an allocation to a low

covering factor investing which will focus on the most

We also need to be wary of taking unintended risks when selecting low volatility investments. A prime example includes sector and country concentrations, such as the healthcare sector in the MSCI Minimum Volatility Index. This sector has been performing well

•

Based on analysis of the historical performance of the low volatility factor, we expect the market environment to be broadly supportive for the strategy over the next 12 months, as interest rates remain very low and equity markets remain more volatile than the historical average. Nonetheless, performance has been strong for a prolonged period and valuations are now expensive, whilst investor popularity has become an increasing concern. We would recommend moves towards profit taking at this time and would no longer advise adding to positions.

not because the stocks are low volatility but due to sector specific developments.



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Factor investing and low volatility What is factor investing?

What is the low volatility premium?

Equity factors are premiums that explain the risk and return

Low volatility stocks are those that simply display low average

characteristics of a particular stock or set of stocks. A large

variation in their prices as measured by statistical measures,

body of academic and empirical research supports the

such as variance or beta. These companies have very steady

theory that gaining exposure to factors results in long term

earnings streams in established sectors with established

outperformance versus the key benchmark market cap index.

products. High growth, innovative companies usually don’t

The best known factor is the one that every investor in equities gains exposure to, whether intentionally or not. This is the market factor, known better as beta. The theory goes that investing in high beta stocks, or those with higher

volatility stocks are more usually found in the so-called “boring”, defensive sectors, such as utilities, telecoms and consumer staples.

variability in relation to the market, should be rewarded

The standard theory of investments (the Capital Asset

with higher returns. But this theory has been challenged

Pricing Model or CAPM) states that an investor needs to

by the identification of the low volatility factor where the

be compensated for taking on extra risk through enhanced

reverse seems to be true — taking lower risks has actually

returns. In other words, returns and volatility should go

yielded higher returns versus the market cap index over

hand-in-hand and move in the same direction. The low

the long term.

volatility factor goes against this. An investor can earn

Nowadays, the common consensus is that there are several factors that can attract a long term premium over the benchmark index. Amongst the most popular are the aforementioned low volatility, value, small size, momentum, high dividend yield and quality factors (see our previous note, Investing in quality stocks – often a good hedge but not always a good investment for further discussion of this factor).

4

fit the bill and their stocks are much more volatile. Low

Factor Investing: What’s the big deal with low volatility equities?

superior or largely unchanged returns versus the market cap index but with less risk or volatility — a higher Sharpe ratio in other words. Since its discovery, debate has raged on whether this phenomenon is simply an anomaly, and therefore temporary in nature, or a sign that CAPM is incorrect and needs revision.

Low volatility equity performance Low volatility stocks have delivered outperformance over the long term... Many academic researchers have noted the outperformance

We have represented the performance of the low volatility

of low volatility stocks for data as far back as the 1960s. The

factor using two common alternative, or smart beta, indices.

most famous names in the field of factor premium research,

Namely, the MSCI All Country World Minimum Volatility

Eugene Fama and Kenneth French, have published on this

Index and the MSCI All Country World Risk Weighted Index.

and the latter’s website contains regularly updated

It is clear from Chart 1 that low volatility has outperformed

performance figures for the major factor premium portfolios.

strongly since the beginning of the century, particularly the risk weighted index (see Table 1 below for details of how the indices are constructed).

Chart 1: The Risk Weighted index was the star performer earlier in the century Q  Minimum volatility   Q  Risk weighted

2.0 1.8 1.6 1.4 1.2 1.0

16 20

15 20

14 20

13 20

12 20

11 20

10 20

09 20

08 20

07 20

06 20

05 20

04 20

03 20

20

02

0.8

Source: Note: Performances relative to MSCI AC World



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…and have been the strongest performer in the last two years, if you pick the right index! Chart 2 is a shorter term version of the one before and it

Along with the longer term chart it is highly apparent that

shows that the minimum volatility index has been a clear

factor performance is cyclical — they do not outperform

outperformer since 2015, although very recent performance

strongly at all times and can, in fact, underperform for

has been less stellar. In contrast, the risk weighted index

multi-year periods. For example, minimum volatility

has lagged.

underperformed between 2009 and 2011, whilst only keeping pace with the market cap index between 2004 and 2008.

Chart 2: Minimum volatility has outperformed strongly in the past two years Q  Minimum volatility   Q  Risk weighted

1.20 1.15 1.10 1.05 1.00 0.95 0.90 Jan 15

Apr 15

Jul 15

Oct 15

Source: Note: Performances relative to MSCI AC World

Nonetheless, if investors can stomach such long periods of underperformance, investing in low volatility stocks can deliver in the long term, but this is likely to be over several years and throughout at least one full market cycle, if not more.

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Factor Investing: What’s the big deal with low volatility equities?

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Going against investment theory - does a low volatility premium exist and, if so, why? Why do low volatility stocks deliver superior risk adjusted returns? The performance of low volatility stocks is a conundrum

In the behavioural category is risk seeking and loss aversion.

and presents an important challenge to standard investment

This is fancy jargon that essentially says investors seek out

orthodoxy. If investors are not rewarded for taking on risk,

stocks with high potential returns over short time periods

why would anyone invest in any volatile stocks? Since

whilst being reluctant to take very large losses and therefore

they clearly do, the concept of low volatility stocks needs

being quick to sell stocks at the first sign of loss. The kinds

some explanation.

of stocks that offer potentially large and quick returns tend

There are three convincing theories for this and are related to the rebalancing effect, investor behaviour and investor constraints. The rebalancing effect is related to how low volatility portfolios are constructed. The next section goes into the construction details but essentially, the portfolio employs a mechanism to select stocks that display low volatility (or that contribute to low overall portfolio volatility), while excluding stocks that are high in volatility. Therefore, when a stock suddenly becomes more volatile, it is excluded from the index or its weighting falls, thus automatically rebalancing the portfolio. Academic research has shown that high volatility stocks tend to underperform low volatility stocks over subsequent periods1, so removing these from the portfolio reduces the risk of having stocks that will fall substantially in value. More generally, there is a widely held view that automatic rebalancing rules play an important

to have higher volatility than average and often have lower quality balance sheets. Just like all speculation, sometimes these small companies become the next corporate titans, but the vast majority do not. Volatile stocks are bid up in good times by speculators in search of big returns while stocks promising lower, albeit steadier, returns are less preferred. This means that low volatility stocks tend to underperform in rising markets but tend to outperform strongly in down markets. The cumulative effect is long term outperformance relative to the market cap index. In terms of investor constraints, there are several, such as the need to use leverage to make acceptable short term returns when it is not always available or benchmark focused portfolio managers who see low volatility stocks as introducing too much tracking error. The result is that low volatility stocks are less preferred in these cases too, and the low volatility premium is accentuated.

role in enhancing performance versus market cap indices, which do not rebalance.

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See, for example, NBER Working Paper Series High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence, A. Ang, R.J. Hodrick, Y. Xing, X. Zhang.

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How to invest in the low volatility factor The construction of low volatility indices The key problem with investing in low volatility stocks is

The most popular passive indices tend either to weight stocks

that you can only use past volatility as a yardstick when

based on a history of price variance (or standard deviation), or

what you really want to use is future volatility. It is a case

they use a mean-variance optimizer model, which exploits the

of extrapolation that does not guarantee a portfolio of

fact that combining stocks that move in very different ways

low volatility stocks on a consistent basis. Furthermore,

with different levels of volatility can reduce the volatility of

picking only low volatility stocks is likely to lead to a rather

the overall portfolio without hurting returns. Table 1 outlines

concentrated portfolio, leading to lower capacity than the

the weighting criteria for a selection of the most popular low

market cap index.

volatility alternative (smart beta) indices.

We prefer actively managed low volatility funds, because they can take into account factors such as valuations, but we also recognise that this is not always possible. Therefore, we think that passive low volatility indices can provide a similar, if imperfect exposure to the factor.

Table 1: Weighting schemes of selected low volatility passive indices Stock weighting scheme Uses a mean-variance model, to determine MSCI Minimum volatility

the portfolio with the lowest total variance from the parent MSCI index

Constraints Minimum and maximum weights on stock, sector and country allocations. Maximum deviations from the parent index weights for smaller stocks

Uses three year historical weekly return MSCI Risk weighted

variance and reweights all stocks in the parent index according to the inverse of

None

this statistic. No stocks are excluded Uses the FTSE All World as the parent index FTSE Global minimum variance

and applies a mean-variance optimisation process to determine the portfolio with the lowest total variance. Similar to MSCI but the algorithm is different

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Factor Investing: What’s the big deal with low volatility equities?

Maximum weights on stock, sector and country allocations. Diversification constraint at rebalancing, imposing a minimum number of stocks in the index

Many ways to peel an onion — minimum volatility versus risk weighted indices As Table 1 shows, there are many approaches to constructing

On the other hand, the risk weighted index only achieves

a low volatility passive stock index, each with their own

a small reduction in risk as measured by beta, whereas the

advantages and disadvantages. The two broad types of low

minimum volatility index achieves the lowest beta out of all

volatility index are model based, like the MSCI Minimum

the smart beta indices. Large numbers of stocks are excluded

Volatility index and rules based, like the statistics for these

from this index. More generally, we should be aware that

two MSCI Risk Weighted index. Table 2 shows selected risk,

the turnover costs of smart beta indices are higher than the

return and valuation indices, compared with the market cap

market cap index. Note that the MSCI indices used in Table 2

index and other smart beta indices.

have turnover constraints but they all still have much higher

Both achieve a better long term risk adjusted return, as measured by the Sharpe ratio, than the market cap index. However, the big advantage of the risk weighted index is that it contains all of the stocks of the market cap index, just weighted differently. This means that it faces far fewer capacity constraints than the minimum volatility index,

turnover than the market cap index. More buying and selling of stocks will eat into index returns and should be taken into consideration because passive index investing requires a replication of the index in an Exchange Traded Fund, for example. Therefore, the theoretical returns of the benchmark may not be fully reflected for the investor.

which only contains a little over 14% of the market cap index.

Overall, it is clear that the minimum volatility approach would

It is also a cheaper index, based on valuation metrics.

be the best passive alternative equity index to use for risk reduction purposes. The risk weighted approach would be a return enhancement tool compared with the market cap index but is unlikely to offer significant downside protection.

Table 2: Statistics for selected MSCI passive smart beta indices compared with the MSCI AC World index MSCI AC

Minimum

Risk

World

volatility

weighted

No. of stocks

2,480

349

Beta

1.00

10yr Sharpe ratio

Quality

Momentum

Value

2,480

498

492

1,322

0.60

0.90

0.90

0.90

1.00

0.26

0.61

0.47

0.49

0.33

0.21

Tracking error

0.00

7.39

5.04

4.66

7.89

3.80

Turnover %

3.20

20.70

20.60

25.00

144.20

22.30

Price/Earnings ratio

19.00

21.80

18.70

19.00

24.70

17.10

15.40

18.40

15.50

17.00

19.50

13.80

Price/Book value ratio

2.00

2.60

1.76

4.70

3.30

1.50

Dividend yield

2.70

2.70

2.80

2.30

1.60

3.60

Price/Forward earnings ratio

Note: All indices are the All Country World index versions from MSCI, all figures correct as at end April 2016



Aon Hewitt

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A low volatility allocation can enhance portfolios’ risk and return characteristics The degree to which global equities and low volatility indices

In Chart 3, the two lines represent the risk and returns of

move in the same direction, or the correlation, is less than

several different portfolios of stocks and bonds and the same

perfect. For example, the extent to which the MSCI World

combination but with 10% of minimum volatility included.

Minimum Volatility and MSCI All Country World indices

The results clearly show that this addition either enhances

move together is around 90%. While this is high, students of

returns for any given level of risk or, seen another way,

modern portfolio theory will tell us that this can still have a

reduces risk for any given level of return (the market data

beneficial impact when added to a stock and bond portfolio.

used goes back to 2000).

Chart 3: Minimum volatility enhances risk and return The efficient frontier of a stock bond portfolio with and without 10% Minimum Volatility Q  Bond Equity Portfolio   Q  Bond Equity Min Vol Portfolio

Monthly return

0.65% 0.60% 0.55% 0.50% 0.45% 0.40% 1.50%

2.50%

3.50%

4.50%

5.50%

Risk (standard deviation) Source: DataStream and Aon

Less-than-perfect correlated investments, of which low volatility is one, are useful when trying to create a well-diversified portfolio that is more resilient to market downturns.

Combined factors can further enhance risk and return characteristics

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As we have mentioned, the outperformance of factor

One possible way to mitigate the cyclical nature of factor

premiums are cyclical, sometimes falling out of favour for

premiums is to invest in more than one. Aon is undertaking

multi-year periods. And, although we recommend investing in

a large scale research project on the subject of combining

factors for the long term, a long period of underperformance

factors into appropriate portfolios for clients and we expect

can get increasingly uncomfortable for investors and trustees.

to report our results later this year.

Factor Investing: What’s the big deal with low volatility equities?

Current risks in minimum volatility Low volatility equity products are becoming very popular amongst investors Low fixed income yields and low potential returns for

popular exchange traded low volatility funds and the iShares

traditional risky assets have seemingly enhanced the

MSCI USA Minimum Volatility ETF in particular has seen large

attraction of low volatility equities for investors. Chart 4

inflows of $5.3bn in the year up to June — the total under

shows the cumulative investor flows into two of the most

management is now up to $13bn.

Chart 4: Investors have been flooding into low volatility equity products this year Cumulative money flow Q  iShares MSCI USA minimum volatility ETF   Q  PowerShares S&P 500 low volatility portfolio

5,500 5,000 4,500

US$ Millions

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 Jan16

Feb 16

Mar 16

Apr 16

May 16

Source: Bloomberg

However, this needs to be put into context and the sums

While we do not think that the increased popularity is an

invested in low volatility equities are still small compared

immediate threat as yet, history has shown us that the more

with the wider market. For example, the largest ETF — the

popular an investment idea gets, the less likely it is to perform

SPDR S&P 500 ETF — has around $180bn of assets under

with the strength that attracted investors in the first place.

management while the total assets under management in

This is worth bearing in mind.

all ETFs recently surpassed $2.2trn.



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The minimum volatility index is in expensive territory Low volatility doesn’t necessarily mean cheap! Indeed, the

This is becoming an increasing problem as has been seen

increasing popularity of the minimum volatility index and its

in recent weeks as broader equity markets have rallied.

strong relative performance since 2014 has made the strategy

This is because expensive defensive stocks are most likely

quite expensive relative to (admittedly short) history and

to be sold in favour of more exciting, pro-cyclical stocks

other strategies. Chart 5 shows the price to earnings ratios of

in equity rallies, thus heightening the extent of minimum

the MSCI market cap and minimum volatility indices. It shows

volatility underperformance.

how much more expensive minimum volatility has become.

Chart 5: Minimum volatility is becoming more expensive Q  MSCI All country world   Q  MSCI World minimum volatility

26 Price to earnings ratio

24 22 20 18 16 14 12

6 l1

Ju

r1 6

Ap

16

n

15

Ja

5

ct O

l1

5

Ju

r1

Ap

15

n

14

Ja

4

ct

O

l1

4

Ju

r1

14

Ap

n

13

Ja

ct

3 O

l1

Ju

r1 3

13

Ap

n

12

Ja

ct

2 O

l1

Ju

Ap

r1 2

10

Source: Datastream

Sector exposures can create unintended risk, especially in the more concentrated indices It is pretty obvious that employing a different weighting

As Charts 6 and 7 reveal, the minimum volatility index has

scheme to the market cap index will create exposures to

a high relative exposure to the healthcare and consumer

countries and sectors that are quite altered. After all, this is

staples sectors, as well as Japanese equities. Since the index

a consequence of taking a view on the market and is one

contains only 350 stocks, developments specific to individual

of the key ways in which performance will differ from the

companies in these sectors or an unforeseen shock to the

parent index. The problem occurs when the index becomes

Japanese market can have a large impact on the minimum

more concentrated.

volatility index. These risks are not related to the low volatility factor and, hence, are unintended.

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Factor Investing: What’s the big deal with low volatility equities?

Chart 6: Sector weightings change a lot when investing in low volatility Q Utilities  Q Telecoms  Q Materials  Q Energy  Q  Consumer staples  Q Industrials  Q Healthcare  Q  Consumer Discr.  Q IT  Q Financials

100

Utilities Telecoms Materials Energy

90 80 70

Telecoms Materials

Consumer staples

Consumer staples

Industrials

60

Industrials

Healthcare

50 40

Utilities

Healthcare

Consumer Discr.

30

Consumer staples Industrials Healthcare Consumer Discr.

Consumer Discr.

IT

IT

IT

20 Financials

10

Utilities Telecoms Materials Energy

Financials

Financials

0 MSCI ACWI

MSCI ACWI minimum volatility

Source: MSCI

MSCI ACWI risk weighted

Chart 7: Country weightings are very altered too Q Other  Q Switzerland  Q Taiwan  Q Australia  Q Canada  Q France  Q UK  Q Japan  Q  United States

100 90 80 70 60

Other

Other

Switzerland Taiwan

Canada

Canada France

United Kingdom Japan

Japan Australia Canada

50

United Kingdom

40 30

Other

Japan United States

United States

20

United States

10 0 MSCI ACWI Source: MSCI

MSCI ACWI minimum volatility

MSCI ACWI risk weighted

Healthcare is an interesting case in point here. Companies

The risk weighted index also has its own set of weights that

in this sector have been performing very well for a couple

are quite different from the market cap index. The “other”

of years now, not because they are low volatility in nature,

category of countries mainly refers to emerging markets,

but because there have been some important positive sector

for example.

specific developments, such as mergers, that have boosted prices and valuations.



As with all smart beta indices, investors need to be keenly aware of the unintended risks that are taken on. Aon Hewitt

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The outlook Minimum volatility is a bond proxy in terms of performance not income From the empirical evidence, the performance of minimum volatility can be seen as a proxy for bonds. As Chart 8 shows, when bond yields fall, minimum volatility tends to outperform the MSCI World index. Equally, when bond yields begin to rise, minimum volatility starts to underperform.

Chart 8: Bond yields and Minimum Volatility performance are closely linked Q  MSCI World/Min. Vol. relative performance   Q  10 year US Treasury yield

Min Vol outperforms

4.5 4.0

9.6 9.4

3.5

9.2

3.0

9.0

2.5

8.8

2.0 1.5

8.6

1.0

8.4 2010

2011

2012

2013

2014

2015

2016

Source: DataStream

This is logical. Interest rates tend to rise when economic

However, a minimum volatility approach does not necessarily

growth and company profits improve, meaning that the

mean that all the selected companies provide an above

equity market rallies under normal circumstances.

average income through dividends despite a larger weighting

Minimum volatility has a low beta so does not rise anywhere

to traditionally high dividend paying sectors, such as telecoms

near as much as the market cap index and underperforms.

and utilities. Therefore, the comparison with bonds does not

Conversely, falling interest rates indicate more difficult and

extend to here. Table 2 shows that the dividend yield of the

volatile economic conditions — companies struggle to make

MSCI Minimum Volatility index is not superior to the market

profits, equity markets fall and minimum volatility falls

cap index and, in fact, the risk weighted index has a slightly

much less.

higher dividend yield. Investors looking for stock portfolios that derive an above average proportion of returns from high and consistent dividend income should look for actively managed funds or passive indices such as the MSCI High Dividend Yield index amongst many others.

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Factor Investing: What’s the big deal with low volatility equities?

The macro environment will remain broadly supportive over the coming months but the period of strong outperformance is coming to an end So will the market environment remain conducive to low

investments in low volatility passive indices, such as

volatility equity returns over the medium term? Or will

minimum volatility. As Chart 9 shows, bond yields have

equities rally strongly and will bond yields rise? If the answer

fallen sharply this year and minimum volatility has

is yes, then we would not recommend adding to or initiating

outperformed quite clearly.

Chart 9: The macro environment to remain supportive but is the best of the performance over? Q  MSCI World/Min. Vol. relative performance   Q  10 year US Treasury yield

Min Vol outperforms

2.6 2.4

9.20 9.10

2.2

9.00

2.0

8.90

1.8 1.6

8.80

1.4

8.70

1.2

8.60 Sep 16

Aug 16

Jul 16

Jun 16

May 16

Apr 16

Mar 16

Feb 16

Jan 16

Dec 15

Nov 15

Oct 15

Sep 15

Aug 15

Jul 15

Jun 15

May 15

Apr 15

Mar 15

Feb 15

Jan 15

1.0

Source: DataStream

In the first half of the year, there was a sharp downward

We don’t think that we will experience a recession in

revision to US and European growth prospects, along with

either the US or Europe but risks are undoubtedly elevated

fewer expected interest rate rises by the Federal Reserve

(especially for Europe now), which should mean that growth

and fresh monetary stimulus from the European and UK

and yield increases will be moderate and equity markets will

central banks. The latter was triggered by the uncertainty

experience bouts of heightened volatility. Table 3 summarises

engendered by the UK vote to leave the European Union.

our view of the key drivers for low volatility stock.



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Table 3: Asset allocation view summary Key drivers

Bond yields

Medium term view

Likely impact on low volatility stocks

Will stay low and will rise only gradually

Outperform

Higher than average with

Equity market volatility

Macro data

occasional spikes Moderate growth at no more than long term trend

Outperform

This all means that we think that the environment will remain

Consequently, we recommend moves towards profit taking

broadly supportive of minimum volatility over the next 12

and would not recommend adding to positions at this time.

months. However, the key risks to this view — high valuations and increased popularity of the strategy — lead us to believe that the best of the outperformance is now behind us.

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Outperform

Factor Investing: What’s the big deal with low volatility equities?

Contacts Koray Yesildag CFA Asset Allocation Specialist T: +44 (0)20 7086 9605 [email protected]

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© Aon plc 2016. All rights reserved. The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: 4396810. Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN

Risk. Reinsurance. Human Resources.