Despite recent outperformance on the equity markets, many investors remain skeptical about diving headlong into stocks. Anemic yields, meanwhile, make fixed income an unattractive alternative. How can clients reel in returns without feeling insecure? Low-volatility funds are one answer.
Why low volatility?
The Capital Asset Pricing Model (CAPM) formalizes the notion that more risk leads to higher expected returns. But historical data doesn’t support this claim, says Bruce Cooper, vice chair, TD Asset Management.
Take all the stocks on the S&P 500 or TSX and divide them into quintiles according to volatility. “If you look at long-term performance, it’s more of a flat line across the various groups of stocks—the most volatile and risky equities don’t produce better returns.”
From March 1997 to March 2013, the S&P/TSX 60 had annualized returns of 7.62%; for the S&P/TSX Composite it was 7.29%. These returns were accompanied by a standard deviation of returns of 16.63% and 16.19%, respectively, explains Michael Cooke, head of distribution for PowerShares Canada.
Compare those figures to the S&P/TSX Composite Low Volatility Index over the same period: annualized returns of 11.6% with a standard deviation of 10.78%.
That means better returns with less risk. By screening for the least volatile quintile, Cooke says, “sometimes you’re not going to get the parent index’s return patterns. In a strong bull market a low-volatility strategy may lag behind a more traditional index product. But there aren’t too many traders who have a consistent ability to time this accurately.”
These products aren’t only for conservative investors, says Bill Tilford, head of quantitative investments at RBC Global Asset Management.
“Think of cash as having zero volatility. Historical volatility for equities is 16% to 20%, depending on the time period. Bonds, on average, are 4% to 6%.”
So, in a typical portfolio there is a huge gap between bonds and equities; low-volatility funds usually have 30% to 40% less volatility than equities, which puts them at 10% to 12%. This fills the gap, he says.
Cooke suggests these products should make up a significant portion of clients’ core equity exposures. “For a Canadian investor with a balanced 60% equity, 40% bond portfolio, 50% to 75% of the equity component can be in a low-volatility strategy. You can build around it with tactical exposures to individual stocks like banks and utilities, or sector-oriented ETFs.”
Tilford suggests, for an ultra-conservative investor, low-volatility funds are a strong choice for the entire equity component.
Kevin Gopaul, senior vice president and chief investment officer, BMO Asset Management, notes some investors are reallocating part of their fixed-income holdings into low-volatility funds.
Building a low-volatility fund
Cooke focuses on standard deviation of returns over the preceding year. From an index like the TSX he picks the 20% that had the lowest realized volatility, and repeats this screening quarterly. “It’s otherwise a passive, rules-based methodological approach,” he adds.
Chris McHaney, a portfolio manager on Gopaul’s team, says beta is the strongest indicator of future volatility. “We select securities that have the lowest betas relative to the broader market over a five-year period,” he explains.
Companies with the lowest betas have the highest weights in the portfolio. Fairfax Financial tops the list; Shoppers Drug Mart ranks second. The top three sectors are consumer staples, financials and utilities, Gopaul says, and the result is “a more diversified portfolio than the market-cap weighted S&P/TSX Composite Index.”
McHaney notes his team reassesses holdings semi-annually. “This gives the best balance between limiting turnover—so you’re not creating potential taxable gains and excessive transaction costs—and using the latest information.”
Tilford suggests low-volatility investing needs to get beyond beta. He uses a fundamental approach that focuses on balance sheets, income statements and other company financials. Three main criteria shape the analysis: stability, quality and growth. Stability screening involves looking at a number of price metrics, including a stock’s drawdown characteristics. Analysts look at how acute its peak-to-trough movement is, and how often the stock shows dramatic drops.
Return on equity (ROE) is another key metric. “ROE volatility tends to mirror a stock’s total return. If a company has a stable ROE of 10%, over time the firm’s total return will be close to 10%,” Tilford explains.
Assessing quality includes determining how management finances operations. “We prefer self-financing companies,” he says.
Tilford also looks at accruals, which are changes in things like accounts receivables and inventories. “We aggregate changes in accruals across the balance sheet and income statements to get a measure of total net accruals. The reason we care about this is management has discretion across all these different accounts. Net accruals provide a clue as to whether the company is under the kind of stress that will bring the stock down 10% or 15%.”
The growth component comes back to ROE and Return on Invested Capital. “We’re interested in companies that are strong on these growth variables, but we’re looking for stable levels. It’s not a growth strategy we’re implementing,” Tilford explains.
Cooper’s low-volatility strategy is based on two key inputs. “Stocks have a certain amount of volatility and some products identify the ones with the lowest amount and bundle them into a fund. This individual volatility is important, but it’s only one input for us,” he explains. The second is cross correlations—how individual stocks behave relative to each other. Volatile stocks that consistently move in opposite directions reduce portfolio volatility. “They wouldn’t make it into a portfolio that screened only by the volatility of individual stocks,” Cooper says, “but they might find a way into our portfolio because of this volatility-reducing diversification.”
Screening only for individual volatility creates a problem. “Say you have a fund that has 20 stocks with the lowest volatility. If they’re all highly correlated, they’ll always move in the same direction. Downward movement will be less than the broader market, but they all lose.” Defensive sectors have top billing in these funds, Cooper says. In the U.S., it’s health care, consumer staples, telecoms and utilities. In Canada, it’s banks, REITs, telecoms and utilities.
“They also tend to have bigger weights to stocks with above-average dividend yields,” he adds, “because these companies are usually highly predictable and have strong fundamentals.”