Low-volatility products have become increasingly popular in recent years but investors may be underestimating the risks inherent in such products, experts have warned.

And it's not simply because past performance is no guarantee of future results. 

“Investors need to consider what could happen to these products when markets turn. They could be shocked by the risks they were unaware they were taking,” Joel Coverdale, managing director for Asia Pacific at risk management solutions provider Axioma, told AsianInvestor.

Take so-called defensives such as consumer staples and utilities, the kind of sectors low-vol strategies typically target. If the interest rate cycle turns upwards, then these sorts of stocks could be more exposed than most.
 
“Relatively speaking, these sectors are likely to exhibit bond-like characteristics and might be more vulnerable to a rising rate environment,” James Cheo, strategist with Bank of Singapore, told AsianInvestor.

Many investors associate low volatility in returns with low risk but nothing could be further from the truth, Coverdale said. "What low volatility implies is merely that the dispersion of returns is low,” he added, noting that investors often fail to consider correlations between different asset classes.

Managing risk

Low volatility strategies, while dating back to the 1970s, have grown in popularity since the global financial crisis and in particular following the growing adoption of factor indexes.

The latter are also commonly known as 'smart beta' and comprise investment strategies that don’t base themselves off traditional market capitalisation-weighted indices but instead target more specific measures, such as dividends or volatility to achieve better risk-return tradeoffs.

According to London-based consultancy ETFGI, the number of exchange traded products (ETFs) and exchange traded products (ETPs)  listed globally climbed 36% from the end of 2016 to 287 by September 2017. 

Assets invested in these ETPs and ETFs also climbed around 20% from $50.2 billion to around $61 billion over the same period.

However, the performance of some of these strategies has been very uneven, Coverdale said He cited ETFDB.com data that shows how the performance of one US high-dividend smart-beta ETF has ranged from up 30% to down 1% year to date.

Coverdale said many exchange-traded funds are constructed simply by gaining exposure to a universe of stocks ranked by their relevant theme metric (high dividend, low volatility, value investing, etc.,), that are equally weighted.

“That is a simplistic method to select [which] stocks to include and doesn’t account for other factors that may influence the final performance,” he said. “The true drivers of returns may have nothing to do with the themes in question (for instance, high dividend) and therefore, nothing is being managed in terms of risk.”

Passively managed low-vol strategies face similar issues and, increasingly, there is a need for active management to reduce over-concentration to any particular sector, according to Bank of Singapore's Cheo.

What's more, he added, when valuations become stretched across all asset classes, as is the case now, the risk of a pullback applies to all strategies, low-vol included.

Complacency

The association of low volatility with low risk has shaped investment behaviour. The relative lack of volatility in financial markets has led investors to become more risk-adventurous.

With 10-year US Treasury yields still below 2.5%, and in some developed markets even negative, and equities at record highs, institutional and wealth investors have been wading more aggressively into higher yielding or higher growth assets such as junk bonds and emerging markets.

But in this there is an element of complacency.

“Investors think the risk is relatively low in these asset classes, and that they can, therefore move up on the risk spectrum. That is a dangerous game,” Axioma’s Coverdale said.

Low volatility levels in financial markets, induced by ultra-loose monetary policies in Europe and Japan (and beforehand the US), have left investors with a false sense of security, agrees Karsten Junius, chief economist at Bank J Safra Sarasin.

Rainer Michael Priess, portfolio strategist at Singapore based Taurus Family Office, also noted that many wealthy Asian investors are “short volatility”—backing strategies (including structured products) that increase the value of investment propositions as volatility decreases.

“That works until it doesn’t,” he told AsianInvestor. Or, to paraphrase former heavyweight boxing champ Mike Tyson, everybody has a plan until they get punched in the mouth.