Download Revisiting the low volatility anomaly

OCTOBER 2015
LEGAL & GENERAL INVESTMENT MANAGEMENT
Index Intelligence.
Revisiting the low volatility anomaly
Compelling empirical support for a low volatility premium has led to significant
interest in low volatility factor indices. Minimum variance strategies are also
proving popular, but investors should take care not to confuse the two.
For professional investors only
Low volatility investing
Traditional portfolio theory is based on the premise that the market portfolio is
the most efficient in terms of risk and return.This theory leads to the conventional
wisdom that investment portfolios cannot offer a better risk/return pay-off than is
offered by the ‘capital market line’ (Figure 1). At the low end of the capital market line
is the ‘risk-free’ rate of return.The further up the line an investment is positioned, the
more risk it involves, but the higher its expected return.
Simon joined LGIM in February
2012, where he is responsible
for Index Strategy, focusing on
developing the institutional index
management business.
Behavioural finance provides support
Behavioural finance is the study of why investors may, at times, make decisions
that appear irrational.This expanding field identifies several concepts that provide
support for the existence of a low volatility premium.
This first of these is known as the lottery effect.This is where investors look to invest
in assets that only have a small potential loss but a large potential gain, despite the
fact that the average outcome might be negative. In this scenario, the possibility of a
loss is many times higher than the possibility of a gain.This behavioural bias is much
like buying a lottery ticket, and implies that investors are more inclined to overpay for
high volatility stocks (with that high potential pay-off) and underpay for low volatility
stocks.
A second behavioural finance concept that lends support to the low volatility effect
is representativeness.This describes how the existence of a handful of successful,
Figure 1: Testing the efficient frontier
10.0%
Minimum variance portfolio and efficient frontier
8.0%
Return
Contribution by Simon Midgen –
Head of Index Funds Strategy
However, a growing body of empirical research indicates that this conventional
theory may be incorrect.The evidence from this research points to the existence
of a ‘low volatility premium’, or a higher return from holding low volatility stocks.
Furthermore, the research suggests that skewing exposure towards lower volatility
stocks could provide better returns at lower overall risk.The majority of support for
this argument comes from the field of behavioural finance which accounts for the
effect of psychological, social emotional and other factors on stock prices.
6.0%
4.0%
Max sharpe
Min volatility
2.0%
0.0%
0.0%
1.0%
2.0%
3.0%
Source: LGIM. For illustrative purposes only
4.0%
Risk
5.0%
6.0%
7.0%
8.0%
OCTOBER 2015
LEGAL & GENERAL INVESTMENT MANAGEMENT
highly volatile stocks is taken as a reason for believing that
all stocks in the same vein are sound investments. However,
investors regularly ignore the fact that this type of stock can be
highly speculative, while low volatility stocks should generally
perform more predictably. In a similar way, the agency effect
highlights the tendency for low volatility stocks to be ignored by
asset managers as they require less attention and support in the
form of fundamental research.This leaves them undervalued.
Lastly, the illusory superiority bias, or overconfidence, is also
thought to provide support for a premium being available in low
volatility stocks. Investors are often overconfident in their ability to
predict the future and the extent of their differences in opinions are
higher for stocks with more uncertainty attached to them. In reality,
it is easier and more practical to express a positive view than a
negative view, and the result is overpricing, and therefore lower
returns, for high volatility stocks in particular.
Comparing low volatility and minimum variance investing
Investors can look to capture the low volatility factor premium by
investing in a Low Volatility Factor Index.This provides exposure
to low volatility stocks in order to capture excess returns from
company share prices with lower than average volatility, beta, and/
or idiosyncratic risk.
Aside from low volatility investing, we are now seeing growing
interest in minimum variance investing, where investors seek a
portfolio that is designed to have the lowest possible risk while still
02
investing in equity markets. As such, minimum variance investing
may appeal to investors who wish to maintain equity market
exposure, but desire a controlled level of portfolio volatility, for
example as part of a de-risking strategy.
Low volatility and minimum variance investing are both valid
strategies and investing in index strategies that track them has
become increasingly popular in recent years. However, it is
important not to confuse the two, as they differ hugely in the
outcome they are targeting, as shown in figure 2.
Low volatility investing seeks to harness the premium in low
volatility stocks whereas minimum variance investing targets
index level volatility reduction, with no explicit return objective.
Minimum variance investing is therefore designed to manage
overall variability, and is constructed with a limited number
of constraints to explicitly target volatility reduction through
diversified outcomes that do not overly impact trading capacity.
With index strategies available that provide access to the merits
of both low volatility and minimum variance investing, investors
have a growing array of tools at their disposal. However, it is
important not to confuse these two similar-sounding approaches
and to select a strategy that is appropriate for individual
investment objectives. In addition, many investors might wish to
combine these strategies with other smart beta factor investing to
better control risk and achieve their desired risk/return outcome.
Figure 2: Sample indices
Objective
Capture the low volatility effect
Achieve minimum volatility
FTSE RAFI All World Low
Volatility
MSCI ACWI Risk
Weighted
FTSE All World
Volatility Factor
MSCI ACWI
Minimum Volatility
FTSE All World
Minimum Variance
No. of constituents
413
2480
864
356
1947
No of constituents in parent
3061
2480
3061
2480
3061
Index objective
Apply the RAFI fundamental
methodology to a universe
of low volatility securities
Reweight market cap
index to give lower
risk stocks higher
weights
Reweight market cap
index to give lower
risk stocks higher
weights
Generate lowest
volatility
Generate lower
index volatility
Source: LGIM, MSCI, FTSE as at 30 September 2015
For further information please contact:
Janice Wu, Head of APAC Sales & Distribution
Email: [email protected]
Important Notice
This material has not been reviewed by the SFC and is provided to you on the basis that you are a Professional Investor as defined in the Securities and Futures Ordinance
(Cap.571) (the “Ordinance”). By accepting this material you acknowledge and agree that this material is provided for your use only and that you will not distribute or otherwise
make this material available to a person who is not a Professional Investor as defined in the Ordinance.
This material is issued by Legal & General Investment Management Asia Limited (“LGIM Asia Ltd”), a Licensed Corporation (CE Number: BBB488) regulated by the Hong Kong
Securities and Futures Commission (“SFC”) to conduct Type 1 (Dealing in Securities) and Type 9 (Asset Management) regulated activities in Hong Kong. The registered address of
LGIM Asia Ltd is Room 902, 9/F, Chinachem Tower, 34-37 Connaught Road, Central, Hong Kong.
The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All non-authorised reproduction
or use of this document will be the responsibility of the user and may lead to legal proceedings. The material contained in this document is for general Information purposes
only and does not constitute advice or a recommendation to buy or sell investments. Some of the statements contained in this document may be considered forward looking
statements which provide current expectations or forecasts of future events. Such forward looking statements are not guarantees of future performance or events and involve risks
and uncertainties. Actual results may differ materially from those described in such forward-looking statements as a result of various factors. We do not undertake any obligation
to update the forward-looking statements contained herein, or to update the reasons why actual results could differ from those projected in the forward-looking statements. This
document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any financial instrument in any jurisdiction
in which such an offer is not lawful. The views expressed in this document by any contributor are not necessarily those of the LGIM Asia Ltd affiliates and LGIM Asia Ltd affiliates
may or may not have acted upon them.
The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Past performance contained in this
document is not a reliable indicator of future performance whilst any forecast, projections and simulations contained herein should not be relied upon as an indication of future
results. Where overseas investments are held the rate of currency exchange may cause the value of such investments to go down as well as up.
We accept no responsibility for the accuracy and/or completeness of any third party information obtained from sources we believe to be reliable but which have not been
independently verified. Legal & General Investment Management Asia Limited, 19/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. www.lgim.com
Authorised and regulated by the Securities and Futures Commission.
M0587_ASIA