The future of low-volatility strategies in South Africa
Adapted from the article ‘Greatest anomaly ever, or legitimate building block? A primer on low volatility strategies’ by Jason Swartz, Investment Strategist at Satrix
Conventional wisdom tells us high risk equals high return, but this does not always fit the data
The notion that high risk equals high return seems to be true in an asset class sense. Equity markets, which have significantly higher fluctuations than, for example, bond markets, have generated superior long-term returns. This is due to their exposure to an equity risk premium. Within equities too, finance theory tells us that high-volatility stocks have a higher expected return than low-volatility stocks. Over the long term, however, low-volatility stocks outperform the market (and high-volatility stocks). This is one of the greatest anomalies in modern finance. Research since the 1970s shows that it is evident and persistent across a range of different geographic regions.
Low-volatility strategies are becoming more popular among global investors
Since the 2008 global financial crisis, low-volatility strategies have increasingly attracted attention as investors have become more aware of the importance of diversification. Investment providers globally have been launching low-volatility strategies, and the uptake in assets is still growing rapidly. These strategies are suitable for investors who want a well-diversified portfolio but who want equity exposure at a lower risk than traditional equity portfolios.
Locally, these strategies offer the potential to deliver superior long-term returns
Low-volatility strategies haven’t gained the same traction in South Africa as overseas. This may be because of a lack of understanding of the role and characteristics of these portfolios, as well as the reasoning behind the premium. However, South Africa is a fertile ground for this strategy. To illustrate, consider a reconstructed, practically investable low-volatility portfolio that is rebalanced quarterly. It uses the performance of the SWIX as a benchmark and the average ASISA General Equity category of funds as a proxy for active manager performance.
The chart and table below show one of the main characteristics of a low-volatility strategy, namely its ability to protect performance during deep correction cycles, leading to lower drawdowns. However, this protection doesn’t come at a cost to upcycle performance. In fact, the domestic market lends itself particularly well to low-volatility strategies, delivering superior risk-adjusted returns over the long term.
Cumulative performance and risk statistics of low-volatility, SWIX and General Equity funds (2001-2016)
Sources: Barra, Satrix
Understanding the nature of the risk exposures of low-volatility strategies is vital
One of the fiercest criticisms of low-volatility strategies is that they generate structural factor exposures (particularly to value and size), or structural sector biases. In the example above, these risk exposures have been neutralised while still delivering the low-volatility premium. Other criticisms include higher trading costs, limited capacity, limited up-capture, as well as concentration and valuation risk. However, strong risk management can mitigate these. Going forward, investment providers must make the theory of low-volatility investing practical to investors and ensure they have the expertise to understand and control all the sources of risk in the portfolio.