Quant Safety Trade Under Fire Just as Stock Volatility Hits
(Bloomberg) -- As the cross-asset calm snaps, one breed of investor is paying through the nose for stocks that hedge doomsday.
Dubbed low-volatility investing, the style beloved by quants has ridden a wave of inflows for 10 straight months as demand for safety booms. That has sent premiums for U.S. companies soaring, just as fears grow that the cohort suffers from overexposure to sector bets like bond proxies.
U.S. companies with muted price swings trade near the highest premium over global peers since February 2018. The 20-day volatility of the MSCI USA Minimum Volatility Index recently rose above the S&P 500, with the gap remaining narrower than the norm -- raising doubts about whether tranquil stocks always live up to their label.
As U.S.-China tensions push investors to stock shelters, it’s all testing the convictions of programmatic traders and fundamental investors alike, spurring them to dig deeper for assets bearing defensive hallmarks.
Just ask Iman Brivanlou. The Los Angeles-based investor is tilting away from pricey U.S. companies in favor of Europe and emerging markets, while screening for broader attributes like consistent earnings.
“Those stocks that are technically defined as low volatility that have a low realized volatility are expensive,” said the portfolio manager for high-income equities at TCW Group Inc., which oversees $200 billion overall.
A defensive allocation has a clear appeal in this market riddled with trade and liquidity fears, easing profit growth and economic angst. The Cboe Volatility Index jumped to as high as 22 this week as U.S.-China tensions re-awakened, before easing to around 19 in Wednesday trading.
Add the propensity of tranquil shares to outperform in the long haul, and U.S. exchange-traded funds tracking the cohort have received consistent inflows for almost a year. Few factors can boast a similar claim.
“Going forward, we all expect there to be much more volatility in the markets than there potentially has been in the past,” said Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management, which oversees about $1 trillion. “So it’s a very good time to think about de-risking even if you’re potentially cutting some of that upside participation.”
But it’s looking crowded out there.
Near-record premiums for U.S. low-vol equities suggest money managers seeking recession hedges should snap up minimum variance strategies in cheaper spots like Europe and Asia, say Sanford C. Bernstein Ltd strategists.
Low-beta names across energy and materials in emerging markets are in favor at Robeco.
“Defensive can be expensive, but doesn’t have to be,” said Jan Sytze Mosselaar, portfolio manager of Robeco Conservative Equities.
Bernstein’s alternative shopping list has a wide geographic sprawl including Nokia Oyj, China Construction Bank Corp., Lukoil PJSC and Walt Disney Co., which trades near a 2015 high at 20 times forward earnings.
Over at Societe Generale SA, Andrew Lapthorne reckons the risk-reward profile of low-vol stocks in Europe is no better than the U.S., citing a relative earnings-yield premium in both regions at “levels normally associated with a crisis.” Instead, he recommends quality stocks that dangle high dividends -- an outperformer in last year’s sell-off.
Andrzej Pioch has a similar read. Low-vol stocks outside the U.S. look more expensive than usual relative to market-cap weighted indexes, according to the fund manager at Legal & General Investment Management. That’s spurring Pioch to ease up exposure to the factor ex-U.S. in order to boost the portfolio’s “value bias.”
The upshot? While valuations can be a famously unreliable gauge for factor performance, the risk is that higher low-vol multiples are tilting portfolios in a different direction. For risk-premia investors riding the strategy, that means they may be more exposed to large caps, and negatively correlated to value shares over growth counterparts.
‘Set and Forget’
One key challenge for all investors is to ease up on sector bias. Mature businesses in real estate and utilities tend to post stable cash flows, meaning a bunch of steady shares are effectively bond-proxies in drag -- acutely vulnerable to gyrations in the interest-rate cycle.
For Chicago-based Hunstad, the risk of “sector biases” is spurring him to hunt for firms that offer low downside swings and stable growth in cash flows, while he snubs underperformers in utilities, real estate and consumer staples.
Benchmarks “mechanically expose investors to low-volatility stocks without any consideration for valuation,” said Jonathan White, head of client portfolio management at the quant equities arm of AXA Investment Managers. “This is a pitfall of ‘set and forget’ indices.”
©2019 Bloomberg L.P.