The Case for Derisking Portfolios with Low Volatility Equities

Executive Summary

With rates at their highest for the past two decades, and fixed income allocation at the lowest due to the bloodbath for duration in 2022, many pension plans intend to reduce their equity allocation to collect the highest coupons they’ve seen for a long time.
In this paper, we argue that all equities should not be treated equally in that reallocation move – while rebuilding a material fixed income exposure makes sense, some equity strategies should not be used to fund this reallocation, namely low volatility equities.

We will start by reviewing what low volatility equities are about, their purpose, and how they work. We will also discuss the concept of the equity premium and how low volatility strategies aim to capture it in a optimal manner before delving into the specific benefits these strategies may provide for pension funds and other institutional investors. We will discuss how they can help in derisking the portfolio, managing the volatility of the funding ratio, and increasing exposure to the equity premium while keeping the plan’s risk in line.

Finally we will analyse the potential advantages of low volatility equity strategies in the current environment of high interest rates, slowing but still high inflation and uncertain growth expectations, and make a case for maintaining or even increasing the allocation to these strategies.

What Purpose Do Low Volatility Equities Strategies Serve?

Low volatility equity strategies aim to provide exposure to the equity premium, which is the expected return on equities over risk-free rates, while minimising the risk associated with equity investments, hence delivering better risk-adjusted returns. These strategies typically involve investing in a diversified portfolio of low-volatility and/or low-correlation stocks, which have been shown to deliver comparable or even superior returns compared to the broader market over the long term, but with less risk. This is contrary to the traditional finance theory, which suggests that higher risk should be associated with higher returns. However, empirical evidence supports the low volatility anomaly, making it an attractive strategy for pension funds that seek to balance return and risk.

Low volatility equity strategies range from naïve volatility ranking schemes, to more sophisticated minimum variance frameworks which capitalise on the pairwise correlation between stocks to provide an optimal low risk portfolio, as opposed to a portfolio of low-risk stocks. The latter provide more robust portfolios but still suffer from the backward-looking nature of risk models, which assume that future volatility reflects past volatility. Therefore, a comprehensive understanding of what risk entails for equities is crucial. This involves utilising a combination of quantitative tools, not limited to traditional risk models, along with prudent human supervision to identify emerging risks. Such an approach is necessary to prevent the mistake of investing in a portfolio that focuses on minimising past volatility, but which remains vulnerable to emerging risks not seen in the past.

Since we started researching the so-called Minimum Variance anomaly in 1995, we have witnessed the superior absolute and risk-adjusted returns delivered by such strategies across geographies and market regimes, as evidenced in Figure 1.

Figure 1: Performance of Unigestion Low Vol Strategies Since Launch

Sources: Unigestion, Bloomberg. Performance is shown gross of fees, in the base currency of each strategy. See the Important Information section for more information on performance.
*Unigestion’s representative account for each regional version of our “low vol” strategies.
** Respective becnhamrk of each Unigestion(*) regional version of thw low vol strategy.
(1)“Global” is represented by Uni-Global Equities World SA-USD, in USD, launched on 17.01.2008, versus MSCI AC World TR Net.
(2)Europe is represented by Uni-Global Equities Europe SA-EUR, in EUR, launched on 04.05.2004, versus MSCI Europe TR Net.
(3)EM is represented by Uni-Global Equities Emerging Markets SA-USD, in USD, launched on 24.03.2010, versus MSCI Emerging Markets TR Net.
(4)Switzerland is represented by Unigestion Swiss Equities Class A, in CHF, launched on 31.10.1999, versus SPI TR.. Data as of 30.06.2023

How to Use Low Vol Strategies in an Asset Mix ?

Beside the attractive long-term profile of low vol strategies, their performance pattern and the diversification characteristics they provide may also be very valuable to any investors wishing to build a robust equity allocation and an optimal asset mix. We explore those benefits in the section hereafter.

Keep Equities While Lowering Risk, or Increase Equities With Steady Risk?

The most obvious case for low volatility strategies is to lower the overall volatility of the equity bucket, and consequently reduce the risk of the asset mix while preserving the equity exposure.

Below is an illustration of such benefits. We computed the volatility of four very basic equities/bonds portfolios, with bonds ranging from 10% up to 50% of the total allocation.

We then replaced part of the equity allocation (represented by the MSCI World) with Unigestion’s low volatility strategy (World).

Figure 2: Volatilities of Traditional Equities/Bonds Portfolios

Sources: Unigestion, Bloomberg. Simulated data as of 30.06.2023, based on weekly returns between 31.01.2008 and 30.06.2023, in USD, gross of fees.

We clearly see a significant improvement of the volatility of the total portfolios when adding more of low volatility strategies in the equity mix.

As per the given example on the chart (orange arrow), replacing MSCI World with Unigestion’s low volatility strategy in a traditional 60/40 portfolio would have resulted in a total reduction in volatility for the asset mix by more than 20% (from 11.4% down to 9.3%)!

In a similar fashion, if an investor wishes to increase a portfolio’s equity exposure while preserving its risk level, using low volatility strategies can be an efficient way to reach this goal.

The red arrow shows that investors could increase their allocation to equities from 60% up to 80%, by replacing a part of the bonds allocation with Unigestion’s low volatility strategy, while keeping the volatility of the total asset mix steady at around 11.5%.

Diversifying Style Bias Within the Equity Allocation

Besides the pure risk characteristics of the portfolio, one should look at the underlying portfolio composition offered by low volatility strategies in terms of sector, country, and style exposures. Other desirable characteristics of the underlying portfolio such as its dividend yield should also be considered.

Over the past decade, capitalisation weighted indices have concentrated massively on a handful of stocks (Figure 3), in particular within the Technology Large Caps (the so-called “S&P7”!), reflecting the unlimited search for higher returns, backed by the unofficial “Fed’s put”, which seemed to minimise the need for risk management techniques.

2022 acted a wakeup call for many investors, with these stocks suffering significant setbacks. However, once again we are seeing some strong levels of complacency for high growth prospects in the stock markets, despite interest rates having reached levels not seen for a very long time.

Figure 3: Sector Concentration in the MSCI USA

Source: Unigestion, Bloomberg. “S&P7”: 7 large tech—oriented mega caps in the MSCI USA: Apple, Microsoft, Google, Amazon, Tesla, Nvidia, Meta. Data as of 30.06.2023.

 

Low volatility strategies are a good way of diversifying away from those speculation traps, as volatility of returns is inherently driven by corporate earnings volatility over the long run, and lower speculation around them. Hence low volatility strategies tend to be invested to a large extent in stocks where visibility on earnings is strong, and where speculative valuaiton is less likely. They are also usually less sensitive to the cyclicality of the economy.

Consequently we believe investing in low volatility strategies like ours is a good way to get exposed to more resilient and less speculative stocks, usually with attractive yields. This is evidenced in Figure 4. The additional dividend yield is even more attractive today – a nice feature when today’s current earning yield for equities puts them on a par with bonds.

Figure 4: Relative Dividend Yield of a Low Volatility Strategy vs MSCI World (ACWI)

Source: Unigestion, Bloomberg. Data as of 30.06.2023.

Is Today a Good Entry Point for Low Volatility Strategies ?

State of the Economy: Slowing but Persistent Inflation, Gloomy Growth

In the first half of 2023, sentiment was driven by a relatively good mix of rapidly falling inflation with growth slowing down and the largest part of rate hikes in this cycle behind us. Easing supply chains and falling energy prices largely contributed to inflation slowdown (Figure5).

Figure 5: World Inflation Nowcasters

Source: Unigestion. Data as of 30.06.2023

Equity Valuations: Extreme Complacency?

Recession risk has somehow stabilised and economic conditions have remained resilient enough to fuel optimism, especially after companies reported better than expected Q1 earnings. This drove market complacency levels close to extreme levels (Figure 6).

Figure 6: Nasdaq Complacency Indicators

Source: Unigestion. Data as of 30.06.2023

Current Attractivity of Low Vol Stocks

With this extreme optimism in 2023, equity valuations have rebounded massively after the 2022 sell-off. However, while big tech has once again led this rebound, valuations of defensive equity strategies such as low volatility became more attractive in that context given the relative rebound for these stocks in 2022 did not see them recover the ground they lost between 2019 and 2021. Their valuations are by no means stretched and can be regarded once again as in “Very cheap territory”.

Figure 7: Relative Valuation of Low Vol Strategies Using Various Metrics

Source: Unigestion, Bloomberg..Data as of 30.06.2023

Looking Forward: Stress Testing the Portfolios

We currently envisage three scenarios for the coming quarters:

• Our core scenario, which we name “mild recession”, reflects a mild recession taking place in most developed countries (this has already started in some countries like Germany). This would be negative for equities, albeit to a limited extent. We assign this median scenario a probability of 60%.
• Our second scenario, named “hard landing”, would see a major hit for the global economy as central banks would struggle to tame inflation and high interest rates would weigh dramatically on the global economy. We assign a probability of 20% to this bearish scenario.
• Finally, our third scenario, “soft landing”, is the most optimistic one, and probably the one investors have hoped for so far this year, propelling equity markets up despite the banking crisis. We assign a probability of 20% to this bullish scenario.

We have stress tested our low volatility strategies against these three scenarios and our portfolio provided strong resilience in the bearish one, attractive outperformance in the core scenario, and an upside lag in line with the philosophy in the bull case, as shown on Figure 8:

Figure 8: Results of Stress Testing the Portfolios

Source: Unigestion, Bloomberg..Data as of 30.06.2023

We will continue to asses the evolution of those scenarios and their probabilities going forward to detect some new and skewed risks which could be mispriced by past volatility. For the time being we are very confident that the current positioning of the portfolio will mitigate the threats currently faced by equities while continuing to capture the growth of the resilient companies we are holding in the portfolio.

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Document issued July2023.