We have found strong empirical evidence of a low-risk anomaly in all equity sectors, in developed and emerging markets, and in both cyclical and defensive sectors. Sector-neutral low-risk strategies appear more efficient at generating alpha than non-sector neutral approaches while reducing exposure to defensive sectors and consequently interest rate exposure.
Evidence of low-risk anomaly in sectors
Our paper “Low-risk anomaly everywhere: Evidence from equity sectors”, shows a low-risk anomaly in equity sectors in developed and emerging markets. The lowest risk stocks in each activity sector generate higher returns than would be expected given their levels of risk, the converse being so for riskier stocks.
Based on consultations with heads of research at large international brokerage firms, we see this as a likely consequence of equity analysts and active fund managers tending to specialise in particular sectors and mainly selecting stocks from those sectors. Also, constraints restricting the deviation of sector weights in active portfolios against their market capitalisation benchmarks are often used by active fund managers, in particular by quantitative managers which tend to go as far as being sector neutral.
Advantages of sector-neutral low-risk investing
Sector-neutral low-risk investing is about investing in low-risk stocks from all sectors rather than almost exclusively in defensive sectors, as tends to be the case with minimum variance strategies and almost all other low-risk equity investments. Our evidence is that sector-neutral low-risk investing appears superior to non-sector neutral low-risk investing. We found an increase of 14% in the risk-adjusted returns of the sector-neutral strategy, which we believe can be explained not only from the low-risk anomaly being found in all sectors but because the low-risk alpha from a given sector tends to show low correlation with the low-risk alpha from another sector. The sector-neutral strategies take advantage of this diversification by investing in low-risk stocks from all sectors.
Low-risk investing without interest rate sensitivity
A primary benefit of sector-neutral low-risk investing over non-sector neutral is the elimination of a negative exposure to interest rate changes. Non-sector neutral strategies, particularly those based on minimum variance algorithms, tend to show a relatively strong negative alpha exposure to interest rate changes.
Table 1 shows the alpha from two low-risk strategies, conditional to interest rate changes. One strategy is the MSCI World Minimum Volatility index (USD). The algorithm used by MSCI attempts to remove factor exposures other than low risk by imposing numerous allocation and factor-relative constraints against the MSCI World index. The second, which we call Sector-Neutral Low Risk strategy, is long-only and invested only in the lowest risk stocks of each MSCI World index sector, with a tracking error control as another means of removing factor exposures against the market capitalisation portfolio.
The results show a negative exposure of the alpha in the MSCI Minimum Volatility index to interest rate changes, with the alpha turning negative when interest rates rise. The alpha of the Sector-Neutral Low Risk strategy is almost insensitive to interest rate changes and remains positive even when interest rates rise.
Table 1: Alpha generated by the MSCI Minimum Volatility index and a Sector-Neutral Low Risk strategy, conditional to monthly interest rate changes. Total returns are gross of management fees, transaction costs and market impact. Jan-1995 to Oct-2014*.
Source: MSCI, FactSet and BNP Paribas Investment Partners.
Empirical evidence suggests it worth considering sector-neutral low-risk equity strategies rather than minimum variance strategies to avoid potential impacts from interest rate exposure and other pitfalls.