Prudence paid with a low-volatility strategy in January 2016 (and not just because the market fell)

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Equity low-volatility strategies have largely outperformed* their market capitalisation benchmarks in the turbulent times for stock markets since the start of 2016. However, the level of outperformance is well in excess of what their level of defensiveness alone can explain. In our view, this is evidence that 44 years after first being identified, the low-volatility premium is very much alive and kicking. In this article we will examine the case of a European low-volatility strategy and explain its recent behaviour.

Low-volatility strategies have an obvious defensive bias: when the market falls they usually tend to outperform. This defensiveness is measured by the beta, which is contingent upon the volatility of the stock and the correlation between the returns of the strategy with those of the market. A defensive strategy has a beta below one, meaning that the security will be less volatile than the market.

Low volatility is not a one trick pony…

However, it is misleading to reduce the low-volatility concept to just one specific aspect. Low-volatility strategies also take advantage of the positive premium paid by low-volatility stocks, which can be separated from that part of their returns arising from their low-level beta and defensive style. This premium, or alpha, is the portion of the total performance that is not explained by the beta. Our research has shown that such a premium exists in all sectors and not just in defensive sectors. To read more on this, see chapter 11 in the recent book on Risk Based and Factor Investing by Emmanuel Jurczenko, released in November 2015.

For instance, in the European universe of stocks, the total outperformance generated since March 2015 using a low-volatility strategy is 8.49%[1]*. It is clear that being underexposed to financial stocks throughout both the China crisis of August 2015 and the January 2016 bear market contributed to the strategy’s overall performance, but it has been quite a bumpy ride, with the semi-recovery in November 2015.

Exhibit 1: Beta contribution to excess returns (since inception) of a European equity strategy invested in the least volatile stocks of each sector

exhibit 1 etienne 2302

Source: BNPP L1 Equity Europe low volatility, January 2016 monthly report

The premium from the low-volatility stocks, in the same strategy and during the same time frame has been more significant. More interestingly, it has also been more stable and more diversified with the Information Technology sector being the top contributor to this premium.

Exhibit 2: Alpha contribution to excess return (since inception) of a European equity strategy invested in the least volatile stocks of each sector

exhibit 2 etienne 2302

Source: BNPP L1 Equity Europe low volatility, January 2016 monthly report

Such good performances may seem unusual, although they are actually in line with the long-term expectations for such a strategy, as is reflected by the long-term back test. Not surprisingly, this performance is understandably creating renewed interest in low-volatility strategies – although it should not require an accident for folk to think about taking precautions! [divider] [/divider]

*past performance is not indicative of future performance.

[1] Source : BNPP L1 Equity Europe Low Volatility, January 2016 monthly report.

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Etienne Vincent

Head of Global Quantitative Management, THEAM

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