Interest in low-volatility strategies has grown since the financial crisis, when investors went looking for less risk and better returns.
But such a strategy, with its yield and defensive biases, is sometimes seen as a bond proxy. So, does a low-volatility strategy work in a rising-rate environment?
Yes, argues MFS Investment Management in its latest white paper.
MFS’s case for a low-volatility strategy rests on empirical evidence that shows the strategy mitigates more downside in falling markets than lags the upside in rising markets.
MFS studied low-volatility strategies in several rising-rate periods since 1987. It found that high interest rates corresponded with strong equity performance led by volatile industries. While the least volatile stocks underperformed during those times, they averaged returns more than 10% on an annualized basis. Often, sharp market corrections followed the rallies led by high-volatility stocks.
“Not only have these [less volatile] stocks provided strong absolute returns during rising rate regimes,” says the report, “they have also maintained a defensive bias in the event of a market correction following a period in which higher-beta stocks have led the market.”
The low-volatility strategy is well-suited to a strategic allocation since its potential benefits are garnered over a minimum of one market cycle, reveals the paper.
Using data since the financial crisis, the paper shows relative performance of the least volatile quintile of the market, represented by the MSCI All Country World Index and by U.S. total returns.
The least volatile quintile performs in line with a defensive low-volatility equity strategy — providing a cushioned decline in downmarket periods and good equity upside participation in the upmarket periods.
But is the strategy better than using passive ETFs?
The report notes that many low-volatility ETFs invest in stocks based on a single characteristic — price volatility. In contrast, active low-volatility strategies make investment decisions based on many long-term drivers of stock prices, like valuation, earnings growth, management and so on. Thus, in a strategic allocation, an investor may be better served in an active strategy than in a passive ETF one.
Read the full white paper here.