Low Vol, A Time Tested Strategy That Pays Dividends

• Over various market cycles, the low volatility strategy has provided investors with superior risk-adjusted returns over other strategies.
• When markets are volatile, a portfolio exhibiting lower downside deviations substantially reduces the returns required to rise back to its original investment value, allowing the portfolio to compound at a greater rate.
• Asia Pacific Ex Japan is an ideal market for investors wanting to implement the low volatility strategy without losing the Asian perspective.

This is a Part One (out of two) article about the Low Volatility strategy and how investors may delve into this strategy with one of the funds available on our platform.

In this piece, we will discuss about why the Low Volatility strategy is becoming increasingly relevant in 2018 and beyond.

Forget About 2017, Volatility Is Here To Stay

Asia ex Japan has long been our favourite regional equity market to invest into. Besides the growth and long-term demographic story that we are all familiar with, the region looks attractive from a valuation standpoint, even after its strong performance in 2017.

Last year was one of the smoothest investment journeys that any one of us could ever hope for. If investors think what happened in February was a mere blip in the volatility charts, they may be in for an awakening.

Based on data sets tracking the month-on-month percentage change in the MSCI Asia Pacific ex Japan Index across 30 years, the results show that the low volatility experienced in 2017 was an anomaly, and should not be projected as future expectations (see Chart 1).

Chart 1: Monthly percentage change in MSCI AC Asia Ex Japan Index since 1988

In a rising interest rate environment, we expect volatility to trend upwards as investors expect to be compensated higher for the increasing risk they undertake.

Some may argue that rising volatility is not a bad thing – after all, it also represents potential upside that could lead to capital appreciation. However, it is important for investors to not focus only on one side of a coin.

It would be wise to take a step back – and question the point of having a strong portfolio performance in a good month, only to be met with a decline of a similar magnitude in the following period. As advocates of long term and value investing, our team at FSMOne would like to remind investors to cultivate patience and discipline towards investing, as yesteryear’s stellar market performance is unlikely to be repeated anytime soon.

For investors seeking a more measured approach to capital growth, one investment strategy they may consider is the Low Volatility strategy. Given risk-adjusted returns is one of the key measures we examine in understanding whether investors are being adequately compensated for every unit of risk undertaken, the Low Volatility strategy is ideal for those who seek superior risk adjusted returns.

Long Live Low Volatility

The Low Volatility strategy is one positioned to outperform during periods of rising volatility and uncertainty. Having outperformed many of its peer strategies over the last two decades (see Chart 2), the cornerstone underpinning the Low Volatility Strategy is to invest in companies that have higher market resilience.

Such companies often exhibit lower beta (beta is a measure of market risk), and usually belong to defensive sectors that can provide persistent returns regardless of market cycles.

But of course picking stocks exhibiting lower market risk is only one part of the equation. Lower volatility stocks may not necessarily fall under “defensive” sectors, especially sometimes when “defensive” stocks are priced expensively, which can negatively contribute to volatility – hence the importance for a low volatility strategy to be diversified across sectors, in providing ample portfolio diversification, and downside protection.

It should be noted that these strategies often have overlap characteristics with one another. For instance, the Quality factor (e.g. low earnings variability) is often present in companies that have low intrinsic volatility.

Chart 2: Performance of Low Volatility Strategy In Asia Ex Japan Relative to Peers

A Low Volatility strategy should return investors superior risk-adjusted performances (see Chart 3), especially over the long-term.

Chart 3: Annualised Returns & Volatility of Strategies (2001-2018)

In a previous article, we talked about the importance of staying invested through market cycles, as a significant portion of portfolio returns are affected by whether investors miss out on the best daily returns. In our findings, missing out the best 10 daily returns would cut your portfolio value by approximately half!

Despite underperforming relative to Quality and Momentum factors in the above time period, the Low Volatility strategy demonstrates the lowest risk to returns ratio, suggesting that investors’ risk exposure is lesser for every unit of return they receive (see Table 1)

Table 1: Downside Deviations And Risk-Return Trade-off of Strategies

Both the High Dividend and Low Volatility factors performed the best in terms of downside deviations, which measures the volatility of negative returns. Typically a lower downside deviation is preferred as the risk of capital loss is lesser.

Low Volatility Investors Gain More By Losing Less

There have been long standing debates about why the Low Volatility anomaly exists since it violates the basic investment premise that risks and returns are linearly correlated. Compared to most strategies, it has been able to deliver pervasive and strong risk-adjusted returns over a long investment horizon.

High beta companies ought to deliver higher returns for the heightened risks they carry, and vice versa. Nonetheless this has not been the case. As we leave it to academics to hash out the differences between financial theory and reality, perhaps one intuitive and simple explanation that many of us can agree on is the effect of compounding on long term portfolio value.

Given the strategy has the effect of preserving capital during down markets and providing persistent returns over a long horizon, investors ultimately gain more by losing less, as the recovery required arising from investment losses can be substantial (see Table 2). As a low volatility portfolio compounds at a more predictable and consistent rate, this effect becomes pronounced over a longer time horizon.

Asia Is Still Cheap

Based on the excess earnings yields (equity yield less global bond yield), Chart 4 suggests that Asia ex Japan as a whole still has a lot to offer to investors over global equities.

Chart 4: Excess Earnings Yields from May 2010 to May 2018

Valuations of Asian markets have also yet to catch up with its global peers, as their aggregate forward P/E and P/B ratios are currently at ~12.6x and ~1.5x respectively, a significant discount over the MSCI AC World Index (see Chart 5).

Chart 5: Forward P/E and P/B ratios of Asian and Global Markets

Asia Pacific Ex Japan: A Market Ripe For A Low Volatility Strategy

Comprised predominantly of many high growth markets, Asia Ex Japan as a region currently enjoys favourable demographic and economic tailwinds, which is expected to translate into strong corporate earnings growth into the future.

Yet, some investors may have been spooked by the market sell-off earlier in February, or the current US-China trade war tensions, and are feeling uneasy about putting their hard earned savings into predominantly growth oriented markets that often begets higher volatility.

If you are one seeking for a better balance between growth and stability without losing the Asian perspective, you may consider the Asia Pacific ex Japan market as an alternative.

Compared to Asia ex Japan, the Asia Pacific ex Japan has a wider investment universe, as it includes other developed markets such as Australia and New Zealand.

Given their favourable dividend imputation tax regimes, these developed markets contribute significantly to the higher dividend yields (see Chart 6) offered by the broader index.

Chart 6: Dividend yields of Asian Indices

How Can I Incorporate The Low Volatility Trade Into My Portfolio?

Characteristics that would reduce the risk profile of a portfolio include investing in highly liquid companies with large market capitalisations to weather all forms of market conditions.

Besides constructing a portfolio of stocks with low correlations relative to one another, a low volatility strategy may also benefit from an income feature, given that investors can continue receiving income should there be adverse market movements.

For those who wish to combine a low volatility strategy with an exposure to Asian markets, we believe the Asia Pacific Ex Japan market ticks all the boxes.

In an upcoming article, we will look at Eastspring Investments – Asian Low Volatility Equity Fund in further detail, as it is a product we think is suited to implement the low volatility strategy we have discussed above.

The Research Team is part of iFAST Financial Pte Ltd.