Daniel Ung (pictured), ETF Strategist, SPDR writes that the events of the past 18 months have shot political risk high up the agenda for investors.
While to all appearances economic conditions remain benign, with muted inflation and a strong outlook pushing equities to all-time highs, the unpredictability of political events on the horizon remains a major concern. The challenge for investors is how to position a portfolio which is protected against such risks, while retaining some chance of achieving yield.
A tactical position in low volatility strategies may be the answer. Less volatile stocks tend to outperform more volatile stocks on a risk-adjusted basis over the long run as they are often able to avoid the worst of downturns.
This phenomenon – also known as the “Low Volatility” phenomenon – is well-documented in financial literature by authors such as Baker and Haugen (2012) and has held true even over short-term periods of significant geopolitical tension. For example, during the escalating war of words between North Korea and the US in the late summer, the S&P 500 Low Volatility Index generated 0.17 per cent, while the S&P 500 itself generated a negative return of -1.36 per cent.
Such outperformance is borne out by a historical analysis of low volatility strategies. The S&P 500 Low Volatility Index has outperformed in down markets 82 per cent of the time between December 1990 and December 2016. During the toughest segment of the financial crisis, for example (October 9th 2007 to March 9th 2009) the Low Volatility Index generated a return of 15.64 per cent. One of the explanations for this relates to the behaviour of investors, who prefer stocks that offer lottery-payoffs, rather than more “boring” (i.e. less volatile) choices.
However, investors may find it challenging to decide which low volatility strategy to choose. A simple low volatility strategy may prove to be more effective than its more complex minimum variance counterpart. This is partly due to more frequent rebalancing, which means the index can respond more quickly to prevailing market events. In addition, only the most defensive stocks will be selected, rather than those which will simply provide a diversifying effect or lower correlation.
Again, the test of history demonstrates that low volatility options have proved to be more robust. In the financial crisis example mentioned above, the S&P 500 Minimum Volatility generated less than half the return of its low volatility counterpart (6.42 per cent.) The same was true during the dot com bubble drawdown of 2000-2002 – while the low volatility index returned 49.8 per cent, the minimum volatility return was 30.32 per cent.
While the waters may now seem calm, it may be wise to adopt a defensive posture while staying fully invested in the equities markets to prepare for uncertain times ahead. This strategy may be particularly suited to those investors who are not required to adhere to any particular benchmarks and who wish to take cover from heightened market volatility while political risk remains so uncertain.