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Taking a lower-risk route
A LOW-VOLATILITY equity investment may stand you in good stead in 2017. Ben Dunn, Eastspring Investments Head of Quantitative Solutions Group, offers insights into the strategy.
Q. What is your outlook for Asia ex-Japan equities in 2017? What are the major opportunities and risks in the offing?
2016 was another volatile year for equities. Entrenched investor fears and ambiguity around the global macroeconomic and geopolitical outlook again led investors to maintain their short investment horizons. Equities in Asia have been largely ignored by investors who have favoured fixed income securities.
However, with the large decline in interest rates over the last three decades, fixed interest returns now appear to be far less compelling, apart from higher yielding Asian and emerging bond markets. It is time for investors in Asia to consider changing exposure towards equities.
If you compare valuations in Asia (ex-Japan) equities against the rest of the world, it is apparent that Asian equities are “on sale”. One measure of valuation, the price-to-book ratio, shows that Asian equities are trading at 1.5 times compared to global markets at 2.1 times and US equities at 2.8 times. Asia is significantly less expensive.
History shows that when investors buy at these discounted levels, returns from Asian equities have been very positive over the next three to five years. However, many investors in Asia only invest following significant rallies in markets and invest when they feel more “comfortable” with the uptrend. Unfortunately, they are typically investing when markets have risen strongly and are quite expensive and consequently they then tend to suffer losses over the next three to five years.
We believe firmly that Asia’s (Asia-Pacific ex-Japan equities) growth story remains intact, valuations remain attractive and fears over a significant slowdown in the region’s growth have been well discounted in equity prices. We think that the growth trajectory for the region should remain stable and gather momentum on the back of moderate growth in developed markets.
While things are looking better at the moment, it is equally important to be aware of risks on the horizon. The potential imposition of protectionist measures in the US and any slowdown in the pace of supply-side reforms in China could easily dent investor sentiment. Geopolitical developments could also make for choppy seas. An increased exertion of influence within South-east Asia by China and a rise in populism across the eurozone could lead to unexpected outcomes and shocks in the market.
Q. How and why does a low-volatility strategy make sense in a portfolio?
The investment landscape is shifting, making it more challenging for investors to remain invested amid volatile conditions. It is critical to leverage innovative tools and a robust investment process to deliver solutions that are future-ready. One way to do this is to consider investing through a manager that exploits a Low Volatility approach.
Since the Global Financial Crisis in 2008, Low Volatility (Low-Vol) equity investing has received increased attention, prompting increasing flows into the strategies. This has primarily been driven by the attraction of lower drawdowns and the higher returns that Low-Vol indices have exhibited globally and in Asia. Over the last decade, investors in Low-Vol have benefited from higher returns than the broader underlying capitalisation (cap) weighted indices with lower volatility, or risk.
A Low-Vol approach to equities offers not only lower risk, but also returns that are similar or superior to portfolios which have higher volatility. This phenomenon runs counter to common financial theory that investors are rewarded for bearing risk (that is, generating higher returns comes with higher risk).
Incorporating a Low-Vol investment product within a portfolio is one way to improve the overall risk-adjusted return.
Low volatility investing works for several reasons. The first is that the portfolios typically fall less in periods of market turbulence. This means they do not have to recover as much as other portfolios to regain their original starting position. This helps to accumulate growth in the portfolio over the long term as markets don’t go up all the time and we must expect periods of drawdown. The Low-Vol approach therefore potentially accumulates greater wealth over the long term as it typically falls less in each period of market decline.
Another reason Low-Vol investing works is a common human behavioral bias known as the “lottery effect”. We all like the idea of something that offers a high return, but frequently the odds of achieving the high return is quite low, such as your chance of winning a lottery.
Investors tend to be caught out the same way. They overpay for stocks that offer the potential for high returns that statistically have very poor odds of actually eventuating. Conversely, they ignore stocks that have smaller gain potential with significantly better odds of making those gains. This means that the near-certain winners with lower but realistic returns tend to be overlooked by the market and these stocks provide significant opportunity for Low-Vol investors.
Q. How much room is there for active manager decisions in the portfolio?
We take advantage of a quantitative or a systematic process when constructing our Low-Vol strategy. Such processes are typically repeatable and try to remove human behavioral biases from portfolio construction. The process does allow for qualitative or human decisions to be part of the process.
We start with a very broad universe of around 3,500 companies across the Asia-Pacific (ex-Japan) region. We reduce this number by removing very small illiquid companies. We want to have a high dividend yielding portfolio so we exclude companies that are below the average dividend yield in each country.
We also do not wish to have a very expensive portfolio which is what many other Low-Vol strategies have become. We have made a conscious effort to remove expensive stocks and stocks with poor analyst sentiment which helps reduce the risk of buying into overpriced stocks that are likely to underperform. We also filter the portfolio on quality factors such as debt to equity to make sure that we are not buying stocks that have high gearing that may not be able to service their debt.
We are left with a universe of around 300 companies that we might own that meet our strict dividend and valuation criteria. We then use an optimiser to produce a portfolio of around 100 stocks that has the lowest volatility after taking into account country and sector weights and other factors. New portfolio positions from this process undergo a human reality check to ensure that the company is satisfactory for inclusion in our portfolio.
Q. How are you guiding investor expectations of returns and risk for such a portfolio?
Low Vol strategies have outperformed the broader market in Asia over the last decade. They typically outperform during periods of elevated volatility and in periods of market drawdown. We also believe that being valuation aware is important.
The Eastspring Investments Asia Low Volatility Fund is an innovative and, we believe, a unique, strategy that aims to minimise volatility at the portfolio level and offer investors a low volatility solution for investing in Asia-Pacific (ex-Japan) equities. There is no exchange traded fund with a similar strategy. The fund benefits from a lower risk profile and a systematic approach which aims to accumulate wealth over the longer term with a high dividend yield and lower drawdowns than the broader market. As a result, it should fit well as a “core” holding for most regional equity investors.