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Low volatility investing to weather uncertain times
IF you have been looking at headlines recently about interest rate hikes in the US, quantitative tightening, higher oil prices, and trade wars, you may be wondering how to manage the resulting market volatility within your investment portfolio.
The later stages of market cycles have historically been more volatile periods, but in this instance, what looked like a Goldilocks economic scenario at the beginning of the year with the primary market drivers in a "just right" setting, is being challenged by a combination of factors. It may be time to consider incorporating some more defensive positioning within your core investment holdings with a low volatility strategy, which is designed to give investors equity market exposure with a more stable return pattern through time. Low volatility strategies typically perform best when markets are volatile.
We have already seen the Fed ratchet up rates twice so far in 2018 - on March 21 and June 13. There are two more Fed meetings this year, and the market is anticipating at least one more increase.
Full employment, together with rising inflation, normally herald the cresting of a growth cycle.
Oil prices have also climbed in recent months with the Brent Crude price per barrel moving from below US$70 at the beginning of 2018 and reaching year to date highs of almost US$80. Futures show the price expected at the end of the year to remain above US$70 per barrel. Sanctions have been reinstituted against Iran by the US, limiting its export ability. This may be good news for oil-producing and -exporting nations, but is a headwind for some Asian countries that rely on imported oil.
North Korea has perhaps been the biggest immediate geopolitical threat, though the Singapore meeting last month between Donald Trump and Kim Jong Un relieved some of the tension. However, as was broadly anticipated, the two sides appear to be miles apart on the pace of and commitment to North Korea's denuclearisation programme.
Other political uncertainties are also dotting the landscape, such as the implementation of Brexit and a potential Italexit, how long the Abe government in Japan and the Merkel government in Germany will retain power, possible dissolution of various defense treaties such as Nato, pressure from China on Taiwan to reunite and millions of refugees in Bangladesh, Turkey and Germany.
But of the factors contributing to market volatility in the last six months, the most potent has been the escalating rhetoric about trade wars and the imposition of tariffs. Global merchandise trade was valued at US$17.5 trillion in 2017, with US trade with the rest of the world representing US$3.9 trillion of that. With Mr Trump's current and threatened trade tariffs, an estimated US$1.3 trillion of that is at risk, mostly with China, which accounts for US$0.9 trillion. Rhetoric or reality, the markets do not like uncertainty and that is what the threats and imposition of some tariffs have occasioned.
Price appreciation of listed securities in any period is driven by a wide range of factors. Many of these are temporary or episodic, some of these are company specific, but some are more persistent across markets and time.
These persistent factors arise either as a reward for taking on additional risk or are the result of behavioural biases of market participants and structural impediments (such as constraints imposed on asset owners).
Some of the broadly recognised factors that fall into this category include the "value" factor (where cheap companies tend to outperform expensive ones), the "quality" factor (financially healthy companies tend to outperform lower quality peers), and the "momentum" factor (recent performance trends tend to persist).
One of the great anomalies that have been researched by academics and practitioners for many decades is "low volatility". Generally, in financial markets, excess returns are seen as a reward for taking on risk. But within asset classes, such as the equity markets, low volatility companies tend to keep up with or even outperform higher volatility ones in the long run.
Low volatility strategies seek to exploit this anomaly by targeting lower volatility return outcomes and, as a result, aim to deliver higher risk-adjusted returns across market cycles - outperforming more volatile indices.
Over the last 10 years, the MSCI All Country World Minimum Volatility and Asia Pacific ex. Japan Minimum Volatility indices have produced higher returns with lower risk than their respective broader market indices. The low volatility result is largely driven by lower drawdowns during adverse market conditions. A portfolio with a smaller drawdown requires less subsequent return to make back this loss, and this helps to accumulate returns over the long term.
In uncertain times, low volatility strategies can help to dampen market fluctuations and give investors additional comfort to stay invested and participate in the market's long-term return. A low volatility equity strategy can also act as a diversifier in a total portfolio, complementing other equity and bond investments. By simply replacing some exposure in Asian equities with a low volatility Asian equity strategy, the resulting portfolio can achieve higher returns but with lower volatility.
- Writer is head of the Quantitative Strategies team at Eastspring Investments