The theory of low-volatility investing

07 May 2015

The ‘low-risk anomaly’ has been around for over 40 years. Empirical evidence shows that low-volatility investment portfolios can produce higher returns than riskier portfolios (in particular when adjusted for risk) while providing some level of downside mitigation1.  This anomaly represents a departure from traditional financial theory – where taking on risk is generally expected to yield greater returns.

Recently there has been a significant body of academic research on this topic. At BNP Paribas Investment Partners, our own ground-breaking research shows that not all approaches are equal. So while the low-risk anomaly presents an important opportunity for investors, they need to be discerning when considering their options.

The Smart Beta market – a history of good intentions and unintended consequences

Low-volatility investing is just one of the strategies that come under the umbrella of so called ‘smart beta’. The concept of smart beta has been around since the early 1970s, when academics challenged the conventional approach of using a market capitalisation weighted portfolio of stocks, leading to ‘smarter’ approaches to fund management. There is a wide range of names for smart beta, including advanced beta, alternative beta, systematic beta, strategic beta, exotic beta and factor beta. The range of potential approaches is very broad and has been the basis of many years of research at BNP Paribas Investment Partners. These include: • risk-based strategies such as risk parity or minimum variance based on risk views to manage risk and increase diversification • fundamental indexing, which builds portfolios using criteria such as companies’ cashflows, profits, dividends or sales, which has been show to derive excess returns from exposures to value (cheap) stocks and smaller capitalisation stocks • factor investing, which builds portfolios intentionally exposed to value stocks, positive trending stocks, the most profitable stocks or the lowest volatility stocks Smart beta portfolios and indices were invented to boost returns relative to conventional market capitalisation weighted exchange-traded funds (ETF) and index funds by capitalising

on potential opportunities for excess return. Smart beta presents a growing alternative to these traditional approaches, as it offers the potential for higher risk-adjusted returns over the long run for just a slightly higher fee than conventional ETFs and index funds.

Since the financial crisis, the development of innovative smart beta strategies has accelerated. Demand from investors is growing, given the search for new sources of returns in the environment of very low interest rates and volatile markets. Furthermore, stung by the repeated pricking of asset-price bubbles, investors are looking for unconventional approaches that do not heavily weight overpriced securities.

With the recent proliferation of smart beta research and products on the market, it is increasingly difficult to differentiate between the various investment strategies. In our view, many strategies and approaches are not achieving their stated investment objectives. Despite increasingly complex methods, many of them have been delivering unintended effects – or factor exposures – and therefore less than desirable outcomes.

The research from our own financial engineering team has found that simpler investment methodologies can remove these unwanted exposures. In addition, with our robust process and investing framework, we can aim to manage risk in a more appropriate way. One of our recent discoveries is that the opportunity presented by the low-volatility anomaly is more widespread than previously thought: reaching across equity sectors and also in asset classes such as fixed income, the anomaly can be found and exploited in almost all markets.

 

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