Low volatility equities funds

We’ve recent had a few discussions about low volatility equities and tail risk hedging, both as part of our thinking about portfolio construction for our own portfolio and consultations with a client about one of his client’s portfolios. Part of this work involved a review of low volatility and tail risk hedged equity funds, which we’ve summarised below.

Funds

We’ve chosen a selection of investable funds to review, and two benchmarks: the MSCI ACWI Minimum Volatility index and the MSCI ACWI index to help us compare low vol funds with the broader market. The data come from Morningstar, and US dollar indices have been converted to AUD for comparison with the funds.

Low vol equity funds
ISINInception DateFund Size
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD1993-05-28
MSCI ACWI NR USD2001-01-01
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq AAU60FSF124082012-01-19$380.86M
Fidelity Global Low Volatility Equity FdAU60FID987672017-12-15$76.26M
Milliman Managed Risk Global Shr-Class AAU60FSF176212015-05-18$14.45M
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETFAU00000WVOL62016-10-11$141.21M
Australia OE Equity World Other
Wheelhouse Global Equity IncomeAU60BFL344632017-05-15$43.14M
  • The MSCI Minimum Volatility index uses quantitative portfolio optimisation to select a fully invested portfolio of stocks with the lowest predicted volatility, subject to a number of constraints.
  • Acadian also uses portfolio optimisation, and also use a quantitative stock selection process designed to boost returns.
  • Fidelity limits its investment universe to stocks rated as attractive by their fundamental analysts, then uses optimisation to find a low volatility combination of these stocks.
  • Milliman uses a different approach – they start with an index portfolio, then use a risk forecasting model to estimate when markets will be more volatile than normal. If it is, they use index futures to reduce the overall portfolio exposure to equities.
  • The iShares ETF is an implementation of the MSCI Minimum Volatility Index. The returns vary slightly due to tracking error and practicalities of implementation, but it also has a shorter history than the underlying index, which means the correlations are somewhat different because there’s less history to estimate them from.
  • Wheelhouse is an options based strategy. They start with a portfolio of stocks that are drawn from those rated as having a “wide moat” (that is, higher quality businesses) by Morningstar. Then they sell options on stocks to generate income, as well as buying options to hedge portfolio risk.

Returns

The performance of the funds has been broadly similar, although Wheelhouse appears to have had been less volatile than the other funds.

The period returns show us the main thing to be aware of: portfolio protection costs money, regardless of how you do it. Long term returns are 4-5% lower for low vol funds than the benchmark index across the various strategies employed, albeit equity returns have been unusually high over the last few years.

Low vol equity period returns
3m1y3y5y
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETF8.05%5.36%8.85%
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq A11.15%10.66%6.46%8.94%
Fidelity Global Low Volatility Equity Fd6.80%7.78%9.52%
Milliman Managed Risk Global Shr-Class A7.55%11.55%8.21%9.66%
Australia OE Equity World Other
Wheelhouse Global Equity Income6.73%6.18%8.50%
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD7.21%2.41%8.55%8.83%
MSCI ACWI NR USD10.37%25.19%12.96%13.88%

Volatility is generally about 20% lower for low vol funds. Wheelhouse is at the low end of the scale, with Fidelity higher.

Low vol equity period volatility
1y3y5y
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETF9.05%9.96%
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq A8.47%9.71%8.70%
Fidelity Global Low Volatility Equity Fd9.68%10.28%
Milliman Managed Risk Global Shr-Class A5.16%9.23%9.01%
Australia OE Equity World Other
Wheelhouse Global Equity Income7.02%7.77%
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD8.72%9.40%8.96%
MSCI ACWI NR USD7.69%11.46%10.32%

In general, the lower return has been more significant than the lower risk – the Sharpe ratio has been lower for low vol funds than the equity market index. In other words, a cash plus equities allocation would have given you higher returns than a low vol fund.

Low vol equity period Sharpe ratio
1y3y5y
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETF0.590.89
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq A1.260.661.03
Fidelity Global Low Volatility Equity Fd0.800.93
Milliman Managed Risk Global Shr-Class A2.240.891.07
Australia OE Equity World Other
Wheelhouse Global Equity Income0.881.09
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD0.280.910.99
MSCI ACWI NR USD3.281.131.35

Correlations

Low vol funds generally have a lower correlation to equities – typically they are built to have a 0.7 to 0.8 correlation. Because low vol funds are more defensive they exhibit correlation to bonds as well. Partly this is because they are more defensive (bonds go up when equities go down), but mainly this is because the more defensive stocks they invest in are “bond proxies” that tend to be more sensitive to interest rates. The Australian equity market and AUD are more correlated with growth, so a portfolio of high quality defensive international equities can have a modest negative correlation to Australian equities.

Wheelhouse uses the Morningstar wide moat (i.e. high quality) focus list as a starting point, so it’s bond correlation and Australian equity anti-correlation is high. It’s at the more defensive end of the low vol equity strategies.

Milliman is less correlated with bonds as it uses a futures overlay rather than defensive stock selection.

Low vol equity asset class correlations
AlphaBondsAust bondsEquitiesAust equitiesICR
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETF-4.7% *1.10 ***1.06 ***0.73 ***-0.010.30
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq A-0.8%0.70 ***0.66 ***0.70 ***0.04 ~0.62
Fidelity Global Low Volatility Equity Fd-5.6% *1.29 ***1.18 ***0.74 ***-0.030.65
Milliman Managed Risk Global Shr-Class A-1.3% ~-0.030.33 **0.83 ***-0.09 **0.62
Australia OE Equity World Other
Wheelhouse Global Equity Income-0.5%0.37 .1.20 ***0.55 ***-0.18 *0.89
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD-2.8% ~1.40 ***1.03 ***0.59 ***-0.14 **
MSCI ACWI NR USD0.0%-0.000.001.00 ***0.03 ***
Signifance key: *** = 0.1%, ** = 1%, * = 5%, . = 10%, ~ = 33%

Breaking returns down into equity styles (here we’re using the Fama-French factor returns from AQR, where we would consider 0.3 to be a large exposure), we can see that Wheelhouse has a substantially lower equity market exposure and higher quality tilt than the other funds. And its negative alpha, while not statistically significant, is better than the others and roughly equal to the fund’s ICR.

Acadian show their quant basis here, scoring highly and evenly on quality, value and momentum.

It’s worth noting that Acadian and the MSCI index both have significant momentum loadings. That’s unusual in active equity strategies. Although momentum is a recognised factor that has positive returns across markets, it’s more common to find a contrarian manager with a negative momentum exposure than a manager with positive momentum exposure.

Low vol equity factor exposures
AlphaMarketQualitySmallValueMomentumICR
Australia ETF Equity World Large Blend
iShares Edge MSCI World Minimum Vol ETF-3.3% ~0.89 ***0.17 ~-0.29 *0.17 .0.24 *0.30
Australia OE Equity World Large Blend
Acadian Global Managed Volatility Eq A-1.7% ~0.80 ***0.25 **-0.010.30 ***0.30 ***0.62
Fidelity Global Low Volatility Equity Fd-3.1% ~0.93 ***0.16-0.17 ~0.100.24 .0.65
Milliman Managed Risk Global Shr-Class A-2.8% **0.89 ***0.18 ***0.01-0.08 *-0.020.62
Australia OE Equity World Other
Wheelhouse Global Equity Income-0.9%0.67 ***0.34 *-0.03-0.20 .-0.070.89
Benchmark
MSCI ACWI Minimum Vol (USD) NR USD-2.0% ~0.80 ***0.54 ***-0.12 ~0.13 ~0.22 **
MSCI ACWI NR USD0.0% ***1.00 ***-0.000.00-0.00-0.00
Signifance key: *** = 0.1%, ** = 1%, * = 5%, . = 10%, ~ = 33%

Holdings analysis

Low vol funds have more defensive stocks across the board.

And they hold lower allocations of growth stocks than the benchmark. Most low vol funds also have lower allocations to value too, with higher core holdings.

Most low vol funds tend to have a higher allocation to the defensive sectors and a more balanced sector allocation overall. Contrary to this, Wheelhouse has large tilt to healthcare. This is presumably due to the influence of the Morningstar moat ratings on stock selection – wide moat companies are concentrated in healthcare.

Drawdowns

If you think of low volatility strategies as tail hedges, the drawdown analysis is very important. Ideally for a tail hedge you want much lower correlation to markets in a severe drawdown than at other times.

In fact, low vol equities often struggle in stressed markets. This is because the correlations that are so important in their portfolio construction process can change suddenly. The MSCI low vol index actually fell by more than the broad market in 2020.

Wheelhouse’s lower equity volatility has stood it in good stead, and we would expect that as a options-based strategy it would do well when volatility spikes. Past performance has been good, but it’s worth asking how much of this was due to sector positioning, as healthcare happened to avoid the worst of the COVID drawdown, rather than due to the options overlay.

Conclusion

Low volatility equities or tail hedging is an attractive idea. But the track record of these types of strategies shows that there’s no such thing as a free lunch: one way or another that protection reduces returns, and it’s not clear that it is more effective than the simpler solution of combining equities with defensive assets in a diversified portfolio.

Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.

This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.

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