Making sense of low volatility investing

Investors considering low volatility equities may be wondering: is the drawdown over? And are additional looming interest rate increases a headwind to their returns? The information expressed herein is subject to change based on market and other conditions and is issued by Intech.

The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization.

This information should not be used as the sole basis for investment decisions. All content is presented by the date s published or indicated only, and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Indexes are unmanaged and cannot be invested in directly. Hypothetical performance results presented are for illustrative purposes only.

Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown.

In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.

The largest non-company specific determinant of equity volatility and returns is the sector in which a company operates. This makes intuitive sense as stocks belonging to the same economic sector will tend to be affected by the same economic, regulatory and technology forces. In addition, some sectors have similar sensitivity to the economic environment. For example, consumer staples and health care firms—two defensive sectors— are less dependent on the rate of economic growth than cyclical sectors such as industrials and consumer cyclicals.

In fact, during corporate earnings contractions non-cyclical, defensive sectors tend to outperform. As a result, defensive sectors display consistently lower volatility and offer cushion during down markets. It turns out that available low volatility products can be deconstructed as unintentional defensive sector strategies as their sector composition is dominated by utilities, staples and health care sectors.

Supported by empirical evidence, we advocate an approach that selects stocks exclusively from defensive sectors as a more deliberate and economically sensible way to build a defensive strategy more resilient to economic recessions and less exposed to downside volatility.

Company-specific Risk This risk is inherent to individual stocks and has three components: a earnings persistence: a decline in earnings power reduces the equity value; b distress: high debt leverage constrains growth and may result in bankruptcy; c valuation: stocks trading at high multiples are riskier and tend to underperform.

Indeed, empirical evidence shows that stocks with specific fundamental attributes such as low earnings quality, high debt leverage, and high valuation multiples historically have significantly underperformed the market averages. Figure 3 shows the excess returns of selected factor portfolios versus the universe average over the period. For example, the stocks in the bottom quintile quintile 5 by accrual ratio underperformed the market average by over basis points per year over the period under study.

Conversely, stocks in the top quintile quintile 1 outperformed by over basis points. A similar return pattern is observed for the other three factors: Companies with high low debt-to-cash flow, high low reinvestment rates and low high earnings yield, under out -performed significantly over the same period. Conclusion Currently available low volatility strategies and indexes are mainly driven by past volatility of stock prices and do not target or maximize returns.

This lack of upside participation impairs their ability to maximize return potential. Our approach is to select only non-cyclical stocks reflecting the historically consistent resiliency of defensive sectors during market downturns and economic recessions. Layering on this economic sector focus; our stock selection is based on refined fundamental and valuation factors that have demonstrated consistent excess returns over different market regimes and economic cycles.

This approach delivers on both goals of mitigating downside risk and maximizing returns.

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The Federal Reserve has already started tapering the bond purchases, which it expects to complete by March. The Fed is expected to begin raising its benchmark interest rate in March. The Federal Reserve may take a more aggressive approach in raising interest rates.

In fact, Goldman Sachs is expecting the Federal Reserve to increase interest rates four times this year. The reading highlighted the weakest growth in factory activity since January due to softness in new orders growth Going on, the latest jobs report for December looks disappointing. The U. Non-farm employment has increased by Johnson : Well, I think first and foremost, investors should be focused, as always, on the very long term.

As we've seen, in each and every market episode that we might experience, these funds aren't necessarily going to perform as investors might expect. We saw this in the case of the drawdown in early And what we saw is that, in many cases, low-volatility ETFs underperformed their more common vanilla counterparts, drawing down even further on the bottom, and what was worse still, though, what should have been expected is that when markets bounced off that bottom and roared higher, these funds lagged quite badly to the upside and gave up, in many cases, most of their outperformance that they had experienced from their inception.

What we've seen more recently for the year to date in is that depending on the day, depending indeed on the week, low-volatility funds have either done better or worse than their common vanilla market-cap counterparts. Indeed, at one point as recently as a week ago, high-beta stocks were outperforming low-volatility stocks for the year to date, reflecting the fact that energy stocks have really been on a tear as a result of the spike we've seen in energy prices. Investors need to understand that, at any given moment, these portfolios might not necessarily perform as expected.

They need to take a deep breath, take a step back, take the long view, and know that fairly reliably over a sufficiently long period of time, they've offered less volatility than owning the market outright. And they've offered depending on the time frame, marketlike returns. Though that promise has been somewhat hindered recently by virtue of the fact that they lagged on the upside as markets rebounded from the depths of the sell-off.

Dziubinski : Then let's probe a little bit more on so far, and how these funds have done as a group in this market. And you know, which strategies have maybe outperformed a little bit more than others. And have there been any surprises here from your perspective? So as the markets were getting rocky, what we saw is that the riskiest stocks were outperforming the market at large, which in turn was outperforming the least risky stocks, which at face value would seem to make absolutely no sense, which, as I mentioned before, really reflects more so than anything the fact that energy stocks have outperformed the broad market by a very wide margin up through that point.

Now, fast-forward to today, one week, hence. And what we see is that the reranking among those same three funds has gotten back to what an investor might expect. So really, I think what this emphasizes more so than anything is the lack of utility that investors will get by peeking in on these portfolios each and every day, each and every week, and even sometimes on a monthly basis. And what we see again over a sufficiently long horizon is that these relationships that we would expect tend to hold and you see that shine through in the long-term risk-adjusted returns of the low-volatility portfolios relative to standard market-capitalization-weighted ETFs, relative to the ETFs that invest in the market's riskiest stocks.

Dziubinski : Ben, let's talk a little bit now about the long term. Give us a couple of low-volatility ETFs that you think are good long-term holdings for a portfolio. In , we expanded our suite of managed-volatility solutions by launching our Global Managed Volatility Fund. In , we launched our Tax-Managed Managed Volatility Fund for tax-sensitive investors seeking lower equity volatility.

We have also introduced our managed-volatility strategies to markets outside of the U. The rest of our industry was, for the most part, slow to adopt these strategies; that is, until the aftermath of the financial crisis and market meltdown.

Since then, interest in low-volatility equity portfolios has taken off. However, we are not content to rest on our laurels. Thanks to our innovative and pioneering spirit, we have continued to affirm our commitment to this space by adjusting our approach to changing market dynamics. Given the robustness of our approach, we believe we are well-positioned to help investors implement such a strategy, either on a standalone basis, or as part of a diversified portfolio. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

This information should not be relied upon by the reader as research or investment advice regarding the funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. Read them carefully before investing. Tap into the experience, talent and passion of our people. Please Register or Login to view this content.

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