Do low volatility stocks have interest rate risk, that’s the question put forward by UBS’ Global Quantitative Equities strategy research team in a research report published at the beginning of this week.
Low volatility investing is a hot topic. This year has seen the highest level of inflows into ETFs ever, and many ETFs follow low volatility strategies. But at a time when the Federal Reserve is preparing once again to increase interest rates, the viability of low volatility strategies is being called into question.
- Risk Parity Market Environment About To Change, Trump Volatility Will Return: BAML
- S&P 500 On Break As Volatility Disappears
- Why Low-Volatility Isn’t Working: “Brexit Broke It”
- The Benefits Of A Lower Volatility Strategy In An Uncertain Market
- Are Low Yields Really Responsible For Low Volatility’s Success?
Most of these strategies are built around defensive equities such as utilities, consumer staples and pharmaceuticals, which proved themselves to be the best sectors to own to profit from the easy monetary policies adopted by central banks around the world since the financial crisis. However, after nearly a decade of attracting investor cash, these equities are now starting to show some signs of strain.
For example, it can be argued that all three of the sectors above are trading at historically high valuations and have accumulated colossal debt loads that will be almost impossible to maintain if interest rates leap higher. Furthermore, past research has shown that those stocks with bond-like qualities, i.e. utilities act like bonds when interest rates move up and down. Put simply; it’s reasonable to assume that utility stocks will head lower if rates move higher.
Do low volatility stocks have interest rate risk?
According to the research from UBS, inflows into so-called low-risk ETFs and mutual funds following low-beta, low-volatility or minimum variance strategies have totalled more than $15 billion this year. The bank’s research shows that on average low-volatility investors don’t need to be concerned about the rate environment. A long-term back test of a low volatility strategy in the US shows that the low-risk effect seems to be robust to changing rates – low-risk names have the highest Sharpe ratio in both the rising rate period from 1946 to 1981 as well as the falling rate period which follows this. Also, a more detailed analysis using time-varying betas shows that the alpha to low risk is sensitive to rates, but that a significant move in rates is needed to drive the expected alpha into negative territory. A portfolio designed to bet against beta had a negative relationship with changes in interest rates but once again a large move was needed to push returns into negative territory.
Here are the bank’s charts, which add a lot more colour to the argument.
Nonetheless, while the back tests conducted by UBS show that low-volatility investors may not have much to fear from interest rate changes, there is a warning in the report. Just as I noted at the beginning of this article, UBS raises a “flag” about low-risk names being expensive and exposed credit risk. The Swiss bank’s analysts believe these names (low volatility high gearing) may underperform as the credit cycle ends.