MFS White Capability Paper Series Focus Month February 212 217 Authors James C. Fallon Portfolio Manager Quantitative Solutions Christopher C. Callahan Regional Head North American Institutional R. Dino Davis, CFA Institutional Portfolio Manager LOW VOLATILITY: THE CASE FOR A STRATEGIC ALLOCATION IN A RISING RATE ENVIRONMENT IN BRIEF There is a robust case to be made for investors to consider a strategic allocation to an actively managed low-volatility strategy and to maintain the allocation through at least one if not more than one market cycle to potentially benefit from the defensive attributes of these strategies over the longer term. The case for a strategic allocation rests on evidence that low-volatility strategies have reduced downmarket risk. Low-volatility strategies have yield and defensive biases, and have come to be seen in some cases as proxies for low-yielding bonds, raising a concern about the timing of a tactical allocation in a rising rate environment. Analysis based on prior periods of rising rates since 1987 suggests that it is best to maintain exposure to low volatility during a period of rising rates. Historical performance data show that the least volatile quintile of the market has provided a cushioned decline in downmarket periods and equity upside participation in upmarket periods. Nicholas J. Paul, CFA Director, Investment Product Specialist Interest in low-volatility strategies has grown exponentially since the global financial crisis, when investors were reminded, once again, of the crippling effects of the drawdown risk inherent in equity investing. Both the risk and return characteristics of these strategies have attracted investor interest. They have delivered market-level returns or better with about 25% less risk than the capitalizationweighted market, producing very attractive Sharpe ratios. 1,2 The case for a strategic allocation to low-volatility equities rests on empirical evidence of the low-volatility anomaly and, particularly, on the asymmetry of relative historical performance. Low-volatility strategies have mitigated more of the downside in falling markets than they have lagged on the upside in rising
FEBRUARY 217 / LOW VOLATILITY markets. In the current environment characterized by heightened economic, policy and geopolitical uncertainty likely to result in increased market volatility, they seek to provide reduced downmarket risk. While acknowledging the merits of the strategic case for the asset class, some investors have expressed concern about the timing of a tactical allocation. The question of valuation has arisen because investor interest in low-volatility stocks led to crowding and peak valuations in mid-216 before the trend reversed direction and assets began flowing out of these strategies as quickly as they had flowed into them earlier in the year. Another tactical concern that has gained traction is the potential impact of rising interest rates on low-volatility strategies. The expectation that the Trump administration will pursue expansionary fiscal policies that will lead to higher interest rates has added impetus to this concern. In this paper, we review the considerations related to these tactical questions, including recent analysis we conducted examining various interest rate regimes since 1987, and make the case for a strategic allocation to low-volatility strategies that allows investors to potentially benefit from active managers investing with a longer-term time horizon. Asset flows Investor interest in low-volatility strategies has been fueled by a few factors in addition to greater risk awareness following the global financial crisis. At the end of 215, interest in high-dividend-earning stocks in defensive sectors like consumer staples, health care and utilities gained momentum, reflected in the spike in exchange-traded fund (ETF) flows seen in Exhibit 1 below. In June 216, after the initial market panic following the Brexit vote, investors became less risk averse and began selling defensive, high-quality stocks, which had become expensive, in favor of riskier, lower-quality stocks, which were perceived as better value. This rotation is reflected in the rapid decline in flows into low-volatility ETFs in the second half of 216, as shown in Exhibit 1. Exhibit 1: Low-volatility exchange traded funds (ETF) flows 3B 2B Cumulative ETF flows 1B -1B -2B 14-Feb 14-May 14-Aug 14-Nov 15-Feb 15-May 15-Aug 15-Nov 16-Feb 16-May 16-Aug 16-Nov Source: Credit Suisse Trading Strategy, ETF flows through 25 November 216. For illustrative purposes only. 2
FEBRUARY 217 / LOW VOLATILITY Valuation Before December 26, low-volatility strategies were consistently priced at a discount, reaching a low of a 3% discount just before the technology selloff (Exhibit 2). Since 26, they have maintained an average premium of 2% for much of the time. After reaching their third-highest peak premium in June 216, these stocks traded at a 7% premium as of November 216. These stocks are now trading at levels that make them more attractive on a valuation basis. Exhibit 2: Price/Trailing earnings for global stocks in least volatile quintile Valuation premium (discount) 4% 3% 2% 1% -1% -2% -3% -4% 199 Global least volatile quintile premium (discount) vs. global universe Global volatility 24-month standard deviation 1992 1994 1996 1998 2 22 24 26 28 21 212 214 6 55 5 45 4 35 3 25 2 216 Volatility (annualized 24-month standard deviation) Note: Based on equal-weighted largest stocks in global universe, rebalanced monthly (Factset, MFS): 1, US, 6 European, 4 Japanese, 2 Asia ex Japan, 2 emerging markets; monthly price/earnings (P/E), using a maximum of 1 (P/E>1 set to 1); universe P/E includes the least volatile 2%; volatility based on standard deviation of 24 monthly total returns, as of 3 November 216. Standard deviation is an indicator of the portfolio s total return volatility, which is based on a minimum of 36 monthly returns. The larger the portfolio s standard deviation, the greater the portfolio s volatility. Impact of rising rates The US 1-year Treasury bond yield has risen about 1 basis points since July 216, and futures prices suggest expectations for further increases in short-term rates. The impact of a rising rate environment on low-volatility strategies is a question in the minds of many investors. Periods of extreme, prolonged rising rates appear to impact the relative performance of low-volatility strategies. As one can see in Exhibit 3, the negative correlation between rates and the low-volatility premium has become more pronounced since 28. Low-volatility strategies have mitigated more of the downside in falling markets than they have lagged on the upside in rising markets. In the current environment characterized by heightened economic, policy and geopolitical uncertainty likely to result in increased market volatility, they seek to provide reduced downmarket risk. 3
FEBRUARY 217 / LOW VOLATILITY Exhibit 3: Rates and relative performance of low-volatility stocks US 1-year Treasury yield 1% 8% 6% 4% 2% 1988 US 1-year yield Return of low-volatility stocks compared to largest 1, US companies 199 1992 1994 1996 1998 2 22 24 26 28 Global Financial Crisis 28 21 212 214 216 7% 5% 3% 1% -1% -3% -5% -7% Rolling 24-month return of least volatile 2% of stocks compared to largest 1, US companies Source: MFS, Factset, as of 3 September 216. See Methodology on pg. 7. Past performance is no guarantee of future results. To examine the question of how low-volatility strategies may respond in a rising rate environment, we analyzed a number of rising rate regimes since 1987. We found that they lasted between 15 and 37 months and tended to coincide with strong equity market performance led by more volatile industries. These periods of rising rates resulted in underperformance by the least volatile 5% to 6% of stocks. Even when they underperformed, however, the least volatile 6% of stocks averaged returns over 1% on an annualized basis. Not infrequently, sharp market corrections followed the rallies led by highvolatility stocks. Our view is that it is best to maintain exposure to low volatility during a period of rising rates. Not only have these stocks provided strong absolute returns during rising rate regimes, they have also maintained a defensive bias in the event of a market correction following a period in which higher-beta 3 stocks have led the market. For instance, the last two periods in which the three-month Treasury bill rose significantly were followed by notable collapses in equity returns: The largest 1, stocks surrendered 5% of their performance in about 12 months. 4 In these episodes, unless one had anticipated when rates had peaked and adjusted allocations accordingly, overweight positions to higher-volatility stocks would have been costly, as those stocks significantly underperformed during the downturn. Clearly, it s very difficult to time optimal entry and exit points for allocations to low volatility. In light of this, our view is that it is best to maintain exposure to low volatility during a period of rising rates. Not only have these stocks provided strong absolute returns during rising rate regimes, they have also maintained a defensive bias in the event of a market correction following a period in which higher-beta stocks have led the market. 4
FEBRUARY 217 / LOW VOLATILITY Case for a strategic allocation Low volatility is intended to be a defensive, diversifying equity strategy, designed to minimize downside risk during market crises while providing potential upside market exposure. This type of strategy may be well suited to a strategic allocation, given that its potential benefits are harvested over a minimum of one market cycle. Exhibits 4, 5 and 6 show the relative performance of the least volatile quintile of the market, represented by the MSCI All Country World Index. In Exhibit 4, the defensive quality of low-volatility strategies is reflected in the relatively better performance of the least volatile quintile during the downmarket years shown on the left (28, 22, etc.). The equity upside potential of these approaches is revealed in the relatively strong performance in the upmarket years shown in the middle and right of the chart. Exhibit 4: Annual total returns of MSCI All Country World Index and least volatile 2% Returns 4% 3% 2% 1% -1% -2% -3% MSCI All Country World Least volatile 2% -4% -5% 28 22 21 2 211 1992 215 214 1994 25 27 1996 21 1997 24 212 1995 1991 26 1998 213 1993 1999 23 29 Source: MSCI, as of December 215. See Methodology on pg. 7. It is not possible to invest in an index. Past performance is no guarantee of future results. In Exhibit 5, a similar picture is shown for the US market, with upmarket and downmarket periods reflected. The least volatile quintile performs in line with a defensive low volatility equity strategy providing a cushioned decline in downmarket periods and a good deal of equity upside participation in the upmarket periods. Exhibit 6 shows the degree to which the performance of the least volatile quintile exceeds the performance of the most volatile quintile during up- and downmarket periods in the United States. As one would expect, the least volatile quintile outperforms on a relative basis by a wide margin during down markets and underperforms by a similar margin during strong market rallies. During more moderate upmarket periods, the least volatile quintile performs more or less in line with the most volatile quintile. In assessing the merit of an active low-volatility approach compared to passive ETFs, it is notable that many low-volatility ETFs invest in stocks based on a single characteristic, historic volatility, whereas active low-volatility strategies make investment decisions based on a number of long-term fundamental drivers of stock prices, i.e., valuation, earnings growth, quality characteristics, management team, industry dynamics, competitive advantages, etc., in addition to price volatility, a better long-term investment approach in our view. In a strategic allocation, an investor may be better served in an active strategy than a passive ETF for this reason. 5
FEBRUARY 217 / LOW VOLATILITY Exhibit 5: US total returns during up and down markets 1% 8% 1, largest US companies Least volatile quintile 6% Returns 4% 2% -2% -4% -6% 11/7 2/9 9/87 11/87 6/9 1/9 5/11 9/11 9/ 9/2 7/83 7/84 6/15 2/16 12/8 6/82 11/9 8/ Source: MFS, Factset. See Methodology on pg. 7. Past performance is no guarantee of future results. 1/2 1/7 12/87 5/9 1/11 5/15 8/84 8/87 1/8 11/8 3/9 4/11 7/82 6/83 Exhibit 6: Relative performance of least and most volatile quintiles in US market 1% 8% 1, largest US companies Least volatile quintile less most volatile quintile relative performance* 6% 4% Returns 2% -2% -4% -6% 11/7 2/9 9/87 11/87 6/9 1/9 5/11 9/11 9/ 9/2 7/83 7/84 6/15 2/16 12/8 6/82 11/9 8/ 1/2 1/7 12/87 5/9 1/11 5/15 8/84 8/87 1/8 11/8 3/9 4/11 7/82 6/83 Source: MFS, Factset. See Methodology on pg. 7. Past performance is no guarantee of future results. Conclusion Historical performance data show that the least volatile quintile of the market provided a cushioned decline in downmarket periods and equity upside participation in upmarket periods. Furthermore, analysis suggests that it may be suitable to maintain exposure to low volatility during a period of rising rates. Investors should note that all equity strategies, including low volatility approaches, are subject to drawdown risk and can experience volatility in line with the markets, even if they are designed to be defensive in nature. In our view, there is a robust case to be made for investors to consider a strategic allocation to an actively managed lowvolatility strategy and to maintain the allocation through at least one if not more than one market cycle to potentially benefit from the defensive attributes of these strategies over the longer term. 6
METHODOLOGY In Exhibit 3, the return of low volatility stocks compared to the 1, largest US companies was calculated as follows: 1. At the beginning of each month, the volatility of each stock in the universe of the 1, largest US stocks by market cap was calculated. Volatility was determined by the standard deviation of monthly total returns over the last 24 months. [Standard deviation is a measure of the dispersion of a set of data from its mean.] 2. An equal-weighted portfolio of the 2% of stocks with the lowest volatility was calculated, as defined above, i.e., the 2 stocks with the lowest total return volatility over the last two years. 3. The total return of this portfolio over the following month was measured (i.e., if the portfolio was formed at the close on 12/31/1997, its return over January 1998 was measured). The portfolio total return is the equal-weighted average of the total returns of the 2 stocks. 4. Over the same period, the equal-weighted return of the universe was measured (1, largest stocks by capitalization). 5. This process was repeated for each month, calculating a return to each of the two portfolios (lowest 2% by volatility and the universe) for each month over the history. 6. Then, again for each portfolio, at each point in time (starting with the 24th month of data) calculate a trailing 24-month compounded return. 7. At each point in time, the difference between the 24-month compounded return for the low volatility portfolio and the universe was taken. This is the dark blue line in Exhibit 3. In Exhibits 4, 5, and 6, the underlying volatility calculation was the same as for Exhibit 3 above, i.e. for each stock, at each point in time, the standard deviation of its total returns over the last 24 months was calculated. Endnotes 1 Minimum-Variance Portfolios in the U.S. Equity Market, Roger Clarke, Harindra de Silva and Steven Thorley, 26. 2 The Sharpe Ratio is a risk-adjusted measure calculated to determine reward per unit of risk. It uses a standard deviation and excess return. The higher the Sharpe Ratio, the better the portfolio s historical risk-adjusted performance. 3 Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. 4 These two periods were October 1998 to October 2 and January 24 to February 27. Keep in mind that all investments, including mutual funds, carry a certain amount of risk including the possible loss of the principal amount invested. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. 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