The Case for a Low-Volatility Global Equity Allocation in Retirement Plans

Authored By: Christine Girvan | Publish Date: June 21, 2018

Skilled active managers have historically been able to add value in volatile markets. This can be done through standalone investment options in defined contribution plans or as part of a de-risking framework with respect to broadening an opportunity set and reducing funded status volatility in a defined benefit plan. Whether in a DC or DB context, low-volatility strategies have shown the ability to mitigate more of the downside in falling markets than they have lagged on the upside in rising markets. However, we would expect low-volatility portfolios to face headwinds during periods when equity markets are strong and producing unusually high returns, particularly if the market is being driven up by non-fundamental factors and more volatile stocks.

Concerns Regarding Current Market Environment

The current market environment is characterized by heightened economic, political, and geopolitical uncertainty ‒ including rising interest rates ‒ that has resulted in increased market volatility which might linger throughout the year. We expect more muted investment returns going forward than in 2017, amid a low-for-longer interest rate environment when fiscal stimulus appears to be waning on a global basis. Interest in low-volatility strategies has grown exponentially since the global financial crisis, when investors were reminded, once again, of the crippling effects of the drawdown risk inherent in equity investing. While our view is that it is best to maintain exposure to low volatility equities over a full market cycle or longer, we think it is especially important to maintain exposure during a period of rising rates. Not only have these stocks provided strong absolute returns historically during rising rate regimes, but 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.1 Overall, low-volatility equities have historically performed better during periods of market stress.

Potential Benefits Of Low-volatility Exposure

Low-volatility strategies have delivered market-level returns or better with about 25 per cent less risk than the capitalization-weighted market, producing very attractive Sharpe ratios.2 Pension fund managers, pension analysts, and plan sponsors face a host of obstacles, including extreme volatility in many segments of the market, the changing demographics of their pension constituents, and unprecedented geopolitical change. A well-implemented, low-volatility portfolio may fit well into both DB and DC plans with suitable objectives, as it could help to lower total plan risk in a DB plan or smooth out an individual member return experience in a DC plan. In either context, a low-volatility strategy may help to maintain a higher level of exposure to equities, in lieu of a less risky asset class, and therefore a higher return potential. And this is important because investment gains outweigh contributions over time (as shown in Exhibit 1).

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This hypothetical example assumes a 40-year investment horizon (1976 to 2015) within the context of the MFS proprietary Participant Savings Model. Retirement age is assumed to be 65 while the beginning contribution age is 26. The beginning participant salary is C$45,000 (at age 22) with two per cent annual wage growth over 44 years (1972 to 2015). The proxy portfolio is a 60/40 blend of S&P/TSX Index and DEX Universe Bond Index over the same time period rebalanced monthly. Fees of 100 bps are applied to each year’s returns. (Data source for proxy portfolio performance: Morningstar Direct). Average annual returns applied each year to portfolio ending balance plus contributions with the assumption that contributions are made uniformly over the course of a year; Employer match is 100 per cent of salary up to four per cent; Employee contribution is four per cent of salary, increasing one per cent per year in first four years and continuing at 10 per cent for remainder of savings life.

How Low-volatility Strategies Can Align With Client Needs

Low volatility is intended to be a defensive, diversifying equity strategy, designed to minimize downside risk during market crises while providing potential upside market exposure. This type of strategy may be well-suited to a strategic allocation, given that its potential benefits are harvested over a minimum of one market cycle. Our research shows that a stock’s volatility ranking based on the standard deviation of 24 monthly returns is a reasonable indicator of its volatility ranking. Low-volatility portfolios may also perform better in markets where highly volatile stocks are unfavourably viewed by investors and reasonably valued stocks of higher quality companies are rewarded by investors. Ultimately, we believe these types of attributes can be rewarded over the long term on a risk-adjusted return basis.

Conclusion

While there are different approaches to constructing a low-volatility strategy, we would suggest looking at one with a portfolio construction process that takes an active, systematic approach targeting volatility reduction and downside risk management, considering both fundamental and quantitative factors. Choosing a low-volatility strategy that features both could solve for the exogenous risks that a purely quantitative strategy may not be able to avoid. In our view, there is a robust case to be made for investors to consider a strategic allocation to an actively managed low-volatility strategy and to maintain the allocation through at least one market cycle to potentially benefit from the defensive attributes of these strategies over the longer term. Low-volatility portfolios can potentially outperform in down markets as downside market exposure can be reduced by avoiding highly volatile stocks.

Christine Girvan is head of distribution at MFS Investment Management Canada.

  1. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
  2. ‘Minimum-Variance Portfolios in the U.S. Equity Market,’ Roger Clarke, Harindra de Silva and Steven Thorley, 2006. The Sharpe Ratio is a risk-adjusted measure calculated to determine reward per unit of risk. It uses a standard deviation and excess return. The higher the Sharpe Ratio, the better the portfolio’s historical risk-adjusted performance.

 

Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication.

 

Christine Girvan’s comments, opinions and analyses are for informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analyses are rendered as of the date given and may change without notice due to market conditions and other factors. This material is not intended as a complete analysis of every material fact regarding any market, industry, investment or strategy.

 


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