Investors in low-volatility strategies may be doubling up
their exposure to government bonds and interest rate risk, according to research.
“Smart investors take this exposure into account when considering to make an investment in strategies based on this phenomenon.”Funds focused on stocks with low volatility have been shown
to outperform traditional indexes—hence their key role in the rise of smart
beta—but they carry a “strong implicit exposure” to interest rates, said Joost
Driessen of Tilburg University, Ivo Kuiper of Kempen Capital Management, and
Robbert Beilo, an independent researcher.
“Our main finding is that the outperformance of low
volatility stocks can be explained by differences in interest rate exposure,”
The researchers calculated that stocks with the lowest
volatility had a duration equivalent to a portfolio with 30% fixed income
exposure. In contrast, the most volatile equities were equivalent to a 100%
short position in bonds.
investors take this exposure into account when considering to make an
investment in strategies based on this phenomenon,” the authors wrote.
are still being compensated for taking on interest rate risk, Driessen, Kuiper,
and Beilo claimed: “We find a large premium for interest rate exposure in the
equity market, a factor two to five times higher compared to the compensation
for the same risk in the bond market.”
The findings echo a report from asset management boutique Greenline
Partners earlier this year, which argued that low-volatility strategies’
outperformance was predominantly driven by falling interest rates over the past
However, while the academics said investors in high
volatility stocks were “implicitly short bonds, resulting in a drag on
performance,” Greenline argued that this was unlikely to remain the case.
“We think [the falling interest rate] environment gave
low-volatility investing a tailwind that will likely not repeat going forward,”
the asset manager said.
Read the full paper, “Does Interest
Rate Exposure Explain the Low Volatility Anomaly?”
Investors: Beware of Rising Rates & Don’t
Count Out the Low-Volatility Factor