The popularity of index investing in recent years is well known.
It has even extended to volatility strategies, giving investors the choice between active low volatility managers and low volatility index exchange traded funds (ETFs).
However, the original idea of passive index investing is to provide low-turnover, low-cost exposure to equity markets.
These principles are watered down in smart beta indices, which are by definition active strategies and can have a high turnover.
Therefore while index strategies offer a transparent and often cheaper alternative to active low volatility investing, in our view it comes with several drawbacks.
These include:
1. Low volatility indices are subject to index arbitrage
Low volatility indices, like every smart beta index, have a low capacity because of possible index arbitrage.
This sounds counterintuitive, as index investing is associated with high capacity. However, this only holds for market-cap weighted indices, not for any alternatively weighted index.
As smart beta indices are public, including their methodology and rebalancing dates, they are prone to index arbitrage by market participants such as hedge funds.
A recent Robeco study found that there is an effect of index rebalance announcements and subsequent stock price movements.
It showed that stocks that are announced to be added to the index rise in price before actually being included in the MSCI Minimum Volatility Index, while the opposite effect is observed for deletions.
Both effects are disadvantageous for index investors as an ETF on the index buys the additions at a higher price and sells deletions at an already lower price. These effects become larger as assets in smart beta ETFs grow.
2. Low volatility indices frequently go against other factors
Both the MSCI Minimum Volatility and S&P Low Volatility Index can have significant negative exposure to other proven factors like value and momentum. Our research shows that this can substantially hurt the performance of any low risk strategy.
For example, although the MSCI Minimum Volatility Index takes into account several risk factors, the index can have a relatively high valuation, as has been the case in recent years.
Figure 1 (below) shows the trailing P/E of the market cap index, the minimum volatility index and Robeco Conservative Equities since inception of our strategy in 2006.
Figure 1: Robeco Conservative Equities since inception
3. Limited investment universe
Most low volatility indices have limited breadth, as only stocks from the parent index are considered.
This is especially the case for regional indices. For example, the popular PowerShares S&P 500 Low Volatility ETF (SPLV) only chooses from 500 stocks.
Our research shows that larger breadth enhances the risk/return profile of factor strategies. We prefer a broad investment universe, which enables us to be selective.
We do not just look for low risk stocks; we want to hold low risk stocks that offer good value and momentum exposure, with a high and stable dividend yield.
4. Too complex or too simple
We consider the MSCI Minimum Volatility Index as too complex and the S&P Low Volatility Index as too simple.
The methodology of the MSCI Minimum Volatility Index is quite complicated, as it uses a quadratic optimisation process, subject to several constraints.
The index relies heavily on correlation estimates, which makes index constituents more difficult to explain.
Moreover, the index can contain low correlation stocks that have a high stand-alone volatility. The classic example are Canadian gold mining stocks – good portfolio diversifiers, but highly volatile stocks.
We prefer low volatility stocks to low correlation stocks, in which we are supported by convincing historical evidence.
Conversely, the S&P Low Volatility Index has an overly simple methodology.
The index relies on just one risk factor, volatility, and just one lookback period of one year. Other factors like value and momentum as well as concentration risks are ignored.
We think the virtue is in the middle. That is, keep process as simple as possible, and as complex as needed.
For instance, we make limited use of correlations, as the beta factor is one of our three low risk factors, next to volatility and credit risk, but do not let correlations take over control in portfolio construction.
Our stock weighing scheme mainly leans on equal-weighting, while having liquidity and concentration limits in place.
5. Sub-optimal rebalancing frequency and methodology
The MSCI Minimum Volatility Index rebalances semi-annually, while the S&P Low Volatility index has a quarterly cycle. We see three drawbacks:
- Between index reviews, new information on individual stock characteristics is ignored and not incorporated in the portfolio;
- Index changes have to be processed in a short period of time, which can be a challenging task for traders, as ETFs do not make use of the continuous market liquidity throughout the year; and
- Cash in- and outflows have to be invested according to the index composition at any point in time.
This creates unnecessary turnover. As an example, if a stock is not attractive anymore and will likely be removed at the next index rebalance, it still has to be bought if the ETF has inflows before this index rebalance.
A better approach is to use cash flows to optimise portfolios, incorporating the latest ranking scores. Inflows are invested in top-ranked stocks, while outflows are used to get rid of the least attractive stocks.
The differences between index rebalancing and cash flow optimisation are summarized in Figure 2 (below).
Figure 2: Rebalancing of index strategy versus cash flow optimisation. Source: Robeco
So, although we see the merits of index investing, as they offer transparent exposure to the low risk factor, we have some concerns with smart beta indices.
The original idea of passive index investing is to provide low-turnover, low-cost exposure to equity markets. These principles are watered down in smart beta indices, which are by definition active strategies and can have a high turnover.
Therefore, taking an active approach is the best way to achieve a low volatility outcome.
Jan Sytze Mosselaar is senior portfolio manager in Robeco’s Quantitative Equities team.
