Possible drawbacks of embracing the "safe investment strategy"
In the world of investing, minimum volatility strategies have gained significant attention due to their unique characteristics. These strategies, more than just a safety trade, offer substantial exposure to interest rates, as demonstrated in a recent analysis.
The economic factors responsible for the strong performance of minimum volatility funds, particularly their bond-like behavior, are manifold. These include a focus on low-risk, defensive equities, strategic sector allocation, and the prevailing macroeconomic environment, such as stagflation or economic uncertainty.
Minimum volatility funds tend to overweight traditionally defensive sectors like consumer staples and healthcare. These sectors provide stable cash flows and earnings less sensitive to economic cycles, similar to bonds. By doing so, these funds aim for consistent, asymmetrical returns with better risk-adjusted performance over full market cycles.
Another key factor is the lower volatility and downside protection these funds offer. By seeking stocks with lower price fluctuations, they reduce downside capture during market downturns, mimicking bond-like stability.
Historically, minimum volatility factors have outperformed during periods of slower growth combined with rising inflation, a tough environment for equities but more typical of fixed income assets' relative stability. This performance can be attributed to investor behavior and the "lottery effect," where investors often overlook less risky companies in favor of higher-risk stocks, leading to persistent demand inefficiencies favoring low-volatility stocks over time.
However, in scenarios where rates rise rapidly, the potential downside to min volatility strategies is substantial. Minimum volatility funds have displayed depressed performance during heightened rate environments, such as during the second half of 2013 and in 2017.
Despite their recent success, it's important to note that min volatility strategies have benefitted from a decade of lax monetary policy and record low yields since their inception. As rates enter a higher, more volatile regime, there will be risk in min volatility portfolios.
In light of the current economic uncertainty, ten-year yields have fallen from 2.7% to near 2% since the start of July. The Federal Reserve has signaled its intention to cut rates in the face of slowing economic growth. Regressions calculated using daily returns of a 120-day rolling window suggest that low volatility stocks behave like bonds, making interest rates a significant factor in their performance.
The correlation between minimum volatility funds like the iShares Min Vol ETF (USMV) and yield changes is 0.2, indicating that min vol returns respond positively to yield increases, but not purely due to interest rate risk. However, there is a substantial divergence in cumulative residual returns between USMV and SPLV beginning in 2015, due to a larger beta associated with SPLV.
In conclusion, minimum volatility funds perform strongly and exhibit bond-like behavior largely because they emphasize stable, defensive sectors, reduce exposure to market swings, and benefit from macroeconomic environments where growth slows or volatility spikes, providing equity exposure with lower risk characteristics akin to bonds.
However, it's crucial to remember that while these strategies can offer stability and downside protection, they may underperform in high-rate environments. As always, investors should carefully consider their investment objectives, risk tolerance, and time horizon before making any investment decisions.
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References: 1. Garrett DeSimone, PhD, Head of Quantitative Research at OptionMetrics. 2. Regressions are calculated using daily returns of a 120-day rolling window to allow for the beta exposure to vary throughout time. 3. The median residual of min volatility for the range -0.121 to -0.16 is 0.26%, while the downside doubles for the opposite positive bin (0.121 to 0.16) at -0.53%. 4. Low volatility stocks are generally composed of profitable, dividend-paying companies with low growth prospects. Low volatility stocks are typically found in defensive sectors such as utilities, consumers staples, and real estate.
Technology plays a crucial role in analyzing and implementing minimum volatility strategies, as advanced algorithms and data-driven models enable portfolio managers to identify stocks with lower volatility and potential downside protection.
In addition, the increasing use of technology in investing, such as robo-advisors and machine learning, could potentially extend the popularity of minimum volatility strategies among individual investors who seek lower-risk investment options in the face of economic uncertainty.
