A chart sent to me by Charles Morris, head of absolute return at HSBC Global Asset Management, indicates why low-volatility index strategies are generating such interest from investors.
[For a detailed, year by year review of the relative performance of volatility as a “factor”, see Xiaowei Kang’s article from the March/April 2012 Journal of Indexes Europe].
Note the total return of S&P’s low-volatility index since 1990 in the chart below (white line), compared with what one might call low-vol’s mirror image, high beta (the S&P high beta index’s total return is shown in the red line).
Despite suffering a period of significant underperformance against high beta in the 1990s and again in 2003 and 2009, low-vol has returned over half as much again as high beta on a 22-year view (over 900% for low-vol, versus 600% for high beta).
But although high-beta stocks did better than their low-vol counterparts during the initial recovery from the bear market low of March 2009, since then they’ve stagnated, while low-vol equities have gone on a tear.
The reason for the remarkable recent performance of low-vol equities is that these stocks typically pay high dividends, and investors have been snapping them up in tandem with any other asset class that can offer enhanced income in the current environment of near-zero rates (preferred stocks, high yield and emerging market bonds, real estate are other fund categories that have also seen substantial investor inflows).
“The dash for yield is a dash for calm,” says Charles Morris. Preoccupied by safety and protecting against downside risk, investors are all chasing the same names.
Here, the ears of any investor with a contrarian bent should be pricking up. And there’s double reason to doubt the sustainability of the yield-chasing trend. Any decent financial history will tell you that chasing income in a low-yield environment is one of the riskiest strategies you can pursue. We’ve seen regulators shift uneasily in their seats this year as they realise they may be sowing the seeds of the next large-scale investment accident by keeping interest rates so low.
“Given the low yields on Treasuries, we are concerned that investors may be inadvertently taking risks that they do not understand or that are inadequately disclosed as they chase yields,” US regulator FINRA said earlier this year in a letter to advisors. The UK’s FSA, apparently worried about the scale of retail buying of funds investing in corporate debt, a notoriously illiquid asset class, asked fund management firms this summer to ensure they could cope with large-scale withdrawals.
So is it time to take a contrarian view by switching from low-vol to high beta, or by shorting the former and buying the latter in a relative value trade? Possibly, but there may be an even better way of exploiting the recent yield-chasing trend.
HSBC’s Morris says he still loves gold (I own it in my pension plan too). Paradoxically, given that commodities produce no income, gold may still be the smartest way of protecting oneself against central banks’ policy of financial repression.