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Low Volatility Equities: Why Now, Why Active?

Against the backdrop of a continuing bull market in equities, investor uncertainty has increased with a number of key economic and geopolitical risks, resulting in rising market volatility.

Investors have logically sought to de-risk* portfolios, and given the low interest rate environment, they have rotated significant amounts of money into defensive equities, resulting in stretched valuations for certain pockets of these stocks. At the same time, equity upside remains attractive as accommodative policy and the potential for trade resolution between the U.S. and China could support future gains. As a result, investors now face three competing objectives: how to de-risk portfolios, without overpaying for defensive equities, while maintaining equity upside.

We believe that active low volatility strategies offer a compelling solution, providing the opportunity for investors to participate in market gains, while protecting against the downside. In addition, while the high costs of defensive positions are not properly accounted for in most passive low volatility strategies, active low volatility strategies can offer risk reduction or dividend income at reasonable valuations.

Why now?

Immediate risk reduction

Investors have been de-risking portfolios in light of economic and geopolitical risks: a decade-long bull market that has led to full valuations, signs of slowing global economic growth, uncertainty around global trade and tariff policies, and increasing volatility in the market as seen in late 2018 and periodically throughout 2019.

While some investors have already de-risked, many will wait to reduce portfolio risk until these are tangible and markets have already corrected. While these investors recognize that risk reduction is important and has a role in strategic allocations, these points remind us that time is of the essence:

  • Investors with shorter time horizons, liquidity needs or regulatory considerations, only reap the advantages of a low volatility investment when risk can be reduced before asset value decline.
  • Since markets can take a while to recover from steep drawdowns, these tail events can be damaging to investors that may need to sell after these declines.
  • Investors may also react emotionally to market declines and be tempted to sell after the decline; low volatility can help abate the destructive temptation to “sell low.”

Maintaining equity upside

With historically low interest rates and bond yields, equity is still highly attractive compared with fixed income. In a generally healthy and still expanding economy with strong corporate earnings, investors need not sacrifice yield by switching to a lower-risk asset class, such as fixed income. Rather, with tightening risk spreads and expensive bonds, it will be increasingly difficult to generate returns with fixed income investments; moreover, low and even negative interest rates suggest that more traditional asset allocation strategies might be less effective in the near term. The case for equity exposure can be further strengthened by noting that despite the economic and geopolitical concerns, corporate earnings and economic growth remain healthy.

Why active?

Overvalued defensive assets

Investors have come to question whether the time has come for the market, the economy or both to retrench. As a result, they have begun to rotate significant amounts of money into defensive strategies focusing on dividends, low risk sectors (e.g., utilities) or passive low volatility strategies. Our research suggests this has led to crowding and expensive valuations in these areas.

  • We estimate that U.S. utilities are 2 standard deviations expensive relative to their trading history (chart 1)
    Passive low volatility strategies, such as the MSCI Minimum Volatility index, are more expensive than the market (chart 2).

Chart 1: valuation of utilities

Data as of September 30, 2019. Source: FactSet, MSCI, FTSE Russell, BMO Global Asset Management. Investments cannot be made in an index.

Chart 2: passive low volatility valuations

Data as of September 30, 2019. Source: FactSet, MSCI, FTSE Russell, BMO Global Asset Management. Investments cannot be made in an index.

Defensive assets are understandably overvalued in equity markets since it is all too difficult to secure decent returns in the fixed income markets today. Furthermore, the continuation of low (even negative) interest rates suggests that more traditional asset allocation strategies may be less effective going forward. With tightening risk spreads and costly bonds, it will be increasingly difficult to hedge equity exposure with fixed income investments. But that leaves investors with the problem: How to lower risk at a reasonable cost, while maintaining the equity upside?

We think the solution is a strategic allocation to an actively managed low volatility equity strategy.

The solution: A thoughtful approach to active risk reduction

Investors need to reduce risk while maintaining an equity upside, but only at a reasonable cost. In other words, if investors turn to low volatility strategies seeking to generate returns by reducing risk, it cannot come at the cost of more expensive valuations.

In the low volatility space, many managers (and many of the passive approaches) tend to examine risk at the individual security level—leading to portfolios with unintended exposures and risks. True low volatility portfolios measure the impact of each holding on overall portfolio risk, which enables holding stocks that diversify the profile of the overall portfolio and typically lead to lower risk outcomes. For example, passive approaches today are incurring significant valuation risk, while active approaches can deliver similar or superior risk reduction without the valuation headwind.

BMO Global Asset Management offers active U.S. and global low volatility strategies that have provided compelling long-term returns, which we believe are ideally positioned for today’s uncertain market, as illustrated on the next page.

Chart 3: global low volatility comparison

Data as of September 30, 2019. Source: FactSet, MSCI, FTSE Russell, BMO Global Asset Management. Investments cannot be made in an index.

Chart 4: U.S. low volatility comparison

Data as of September 30, 2019. Source: FactSet, MSCI, FTSE Russell, BMO Global Asset Management. Investments cannot be made in an index.

Against the backdrop of rising volatility and expensive valuations for risk reduction, an active low volatility strategy that empowers investors to reduce risk at reasonable cost while maintaining equity upside for the long-term is imperative now more than ever.

Originally Posted on January 3, 2020 – Low Volatility Equities: Why Now, Why Active?

The investments and investment strategies discussed are not suitable for, or applicable to, every individual.

All investments involve risk, including the possible loss of principal.

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The MSCI USA Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to the large and mid cap USA equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, in USD for the lowest absolute risk (within a given set of constraints).

The MSCI ACWI Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to large and mid cap equities across 23 Developed Markets (DM) and 26 Emerging Markets (EM) countries.” The index is calculated by optimizing the MSCI ACWI Index, its parent index, in USD for the lowest absolute risk (within a given set of constraints).

The Russell 1000® Index is an index of approximately 1,000 of the largest companies in the U.S. equity market.

The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. Investments cannot be made in an index.

Past performance is not necessarily a guide to future performance.

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