By Mark Barnes, head of investment research (Americas) and Marlies van Boven, head of investment research (EMEA)
One of the more interesting twists in the quarter just ended was the rebound of the Low Volatility factor across a number of equity markets after a long losing streak. This recent turnaround offers a glimpse into the factor’s distinct characteristics, as well as the role it can play in a long-term investment strategy.
Low Vol has been in the doldrums for most of the equity rally from the pandemic lows of March 2020, as would be expected based on its historical return patterns. But its buffering effects came to the fore during the upheaval in late Q3, particularly in emerging markets and Asia Pacific ex Japan, which both suffered steep quarterly declines. Low Vol also modestly outstripped the meager gains in the broad US market. The factor is now in positive territory for the year to date in EM, Asia Pacific and Japan.
Third-Quarter 2021 relative factor returns vs broad market indexes (local currency, %)
Source: FTSE Russell. Data as of September 30, 2021. Past performance is no guarantee to future results. Please see the end for important disclosures.
The global reflation/reopening risk rotation that began last November has been particularly inhospitable for Low Vol. Historically, the factor has tended to underperform when investor confidence is high and markets are rallying. But Low Vol shows its mettle during periods like that experienced in the latter half of Q3, providing ballast when markets are fearful and falling. Well-established academic research has found that stocks with lower volatility (or beta) tend to generate higher risk-adjusted returns than the broad market over longer time frames because of their relatively smoother return patterns.
Low Volatility – relative returns vs broad-market indexes (LC, rebased)
Source: FTSE Russell. Data through September 30, 2021. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Low Vol’s defensive powers derive from its large overweights in less economically sensitive, stable-growth industries, notably consumer staples, telecom and utilities – and lower exposure to high-beta stocks such as consumer discretionary, energy and basic materials. Low Vol also tends to tilt more towards large-cap stocks.
Low Volatility factor – relative industry weights (%) as of September 30, 2021
Source: FTSE Russell. Data as of September 30, 2021. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
We compared the Low Vol factor index to two other defensive strategies in Implementation Considerations for Defensive Strategies, our 2019 white paper that covers a 15-year period ended October 2018.
Our analysis showed that this hypothetical Low Volatility portfolio outperformed the FTSE Developed Index with less volatility over the period examined, translating to a return/risk ratio of 0.59, compared to the benchmark’s 0.49. Low Vol’s recent strength is a reminder that the patterns and timing of factor payoffs differ widely. Investors would be well served to monitor all factor exposures, even those that have long been out of favor.
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