Buying low-volatility stocks has been particularly popular with investors over the last few years. Such popularity seems well deserved: few other strategies are supported to the same extent by both rationale (economic and behavioural underpinnings) and empirical evidence (the low-risk premium has been shown to be persistent across time and markets).

Like all “good things” in life, alas, even the low-risk premium is not immune to challenges. Here I will focus on one of them - namely such a strategy’s sensitivity to interest rates – and discuss briefly the causes of such sensitivity as well as describing how active portfolio management may offer possible remedies.

Low-risk equity portfolios tend to exhibit negative correlation to interest rates: such strategies tend to outperform the broad market when rates are falling and underperform when rates are rising. Hence many investors’ concern for the future performance of these strategies in the current environment, given the possible end of a 30-year bull run for interest rates.

Here are two causes which can explain such negative sensitivity.

To start with, interest rates are normally seen as a “gauge” for the overall state of the economy: rising rates are normally associated with a strong economy. In a strong economic environment - hence generating robust cash flows to firms - more “defensive” low-risk stocks are intuitively expected to fare worse than other more “speculative” stocks. Therefore, rising rates are considered to indicate a strong economy which in turn penalises low-risk stocks relative to high risk stocks. The reverse, naturally, is true for falling rates.

These relationships are due in part to the stability or instability of the relevant companies’ cash flows. Cash flows to low-risk stocks are typically more stable, because of the relative stability of the industries and sectors where they can normally be found. These are typically either sectors whose demand displays low sensitivity to the general economy (such as consumer staples) or heavily-regulated industries (such as utilities and telecommunications) who can’t hike up prices when demand is strong,  while being somewhat protected against financial distress or bankruptcy.

A second reason for the negative sensitivity has to do with the fact that low-risk stocks react similarly to bonds when investors’ risk aversion changes. For example, during “flight-to-quality” episodes, when investor risk aversion increases and interest rates fall, low-risk securities (bonds and low-risk stocks) generally have the potential for higher returns than speculative stocks.

Placing bonds and low-risk stocks into the same mental category creates a link that results in co-movements when interest rates change.

Notwithstanding the above, negative sensitivity to interest rates is not the inescapable price investors have to pay to reap the potential rewards of a low-risk strategy.  Active portfolio management may have the potential to deliver low-risk equity portfolios with relatively less negative exposure to interest rates.

The raison d’être of active portfolio management is the ability to tailor portfolios to the desired risk exposures. How can an active portfolio manager seek to deliver the desired exposure to the low-risk premium without the unwanted consequence of full exposure to interest rates? Two possible solutions are particularly relevant here.

The first solution consists of seeking to control a portfolio’s interest-rate exposure by controlling its sector exposures. Sectors vary considerably in their exposure to interest rates and research indicates that much of the advantage of low-risk equity investing can be gained from within-industry selection of low-risk stocks. It is therefore possible firstly to harvest the low-risk premium within sectors by selecting the appropriate stocks, and then to combine the sectors in order to potentially neutralise the exposure to interest rates or obtain any other level of exposure desired.

The second solution is more sophisticated and in our view potentially even more effective.  If an investor has access to a stock-level measure of interest-rate sensitivity (rather than having to rely solely on the aggregate measure at sector level), that investor may exploit differences in interest-rate sensitivity within sectors as well as across sectors.

To incorporate stock-level measures of interest-rate sensitivity into portfolio construction, a portfolio manager has two options. Firstly, a constraint could be applied at the portfolio level. In this case, the portfolio construction process could seek to build a low-risk, high-return portfolio, subject to the constraint that total portfolio interest-rate sensitivity, as measured by the position-weighted average of the constituent stocks, be above or below some threshold. Secondly, the stock-level measure of interest-rate sensitivity could be incorporated into the relevant risk model that measures stock-level and portfolio-level risk, so that the portfolio construction process is attuned to the diversification advantage associated with holding stocks with offsetting interest-rate sensitivities.

Whether the methodology an active investor uses is more or less sophisticated, the starting point is to be aware that equities can have a material exposure to interest rates. A portfolio construction process that is not mindful of these relationships, or can’t handle them adequately, could well lead to unintended, and potentially hurtful, consequences, particularly in the current interest rate environment.

This is provided for informational purposes only and should not be construed as investment advice.

LEGAL DISCLAIMER

This document was prepared by Acadian Asset Management LLC.   The views expressed within are those of Acadian and are subject to change with market conditions. This is provided for informational purposes only and should not be construed as investment advice, or an offer to sell or a solicitation of an offer to buy any security or obtain business.

This document has not been updated since it was published and may not reflect the current views of the author(s) or recent market activity. Market conditions are subject to change. Historical economic and performance information is not indicative of future results.