Low-Volatility Strategies’ Hidden Risks

The outperformance of the popular smart beta strategy may be hiding a correlation to fixed income, researchers argue.

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,” they wrote.

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.

“Smart investors take this exposure into account when considering to make an investment in strategies based on this phenomenon,” the authors wrote.

Investors 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 50 years.

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?

Related: Low-Vol Investors: Beware of Rising Rates & Don’t Count Out the Low-Volatility Factor