Low-risk stocks have generated superior long-term risk-adjusted returns when compared with high-risk stocks. Low-volatility investing has, therefore, been attracting greater attention as an investment strategy. The benefits of low-volatility investing can be derived through country and sector selection in place of individual stock selection. This strategy is also more liquid, has lower turnover, and is better diversified.
Low-volatility investing, which involves selecting securities and forming portfolios by favoring those with low volatility over specified time periods, has been attracting greater attention as an investment strategy given its outperformance over time compared with traditional active management and capitalization-weighted indices. The authors find that most of the benefits of low-volatility investing in global equities can be obtained through country and sector selection rather than through individual stock selection. They attribute this tendency to the anti-bubble behavior of low-volatility investing because bubbles tend to occur at the country and sector level. Furthermore, this strategy is characterized by greater liquidity and lower turnover, as well as fewer concentrated holdings when compared with a pure stock selection strategy.
How Is This Research Useful to Practitioners?
The authors examine the extent to which country and sector selection explain the benefits of low-volatility investing in global equities. They find that most of the benefits of this strategy can be obtained from country and sector selection. Low-volatility investing via country and stock selection tends to outperform the capitalization-weighted index strategy except during periods of strong market rallies. The authors believe that this performance is because of the anti-bubble behavior linked to low-volatility investing. Bubbles generally occur at the country and sector level and, therefore, are captured by the low-volatility strategy.
Thus, it would seem that the negative returns that take place during market crashes could potentially be reduced by adopting such a strategy. The authors also find that a strategy using country and sector selection is more liquid, has lower turnover, and has lower concentration risk when compared with using purely stock selection. They conclude that country and sector selection is a good alternative to individual stock selection if the investor intends to obtain the benefits of a low-volatility investing strategy in global equities.
Portfolio managers will find the conclusions of this research useful. Because of the benefits already mentioned, portfolio managers could focus less on individual stock selection if they intend to capture the benefits of low-volatility investing.
How Did the Authors Conduct This Research?
The authors assess the impact of country and sector effects by first creating single sector, country, or country–sector cap-weighted baskets of stocks from the MSCI World Index. They then compare the historical performance of the low-volatility country and sector selection strategy with that of the minimum predicted risk portfolio of individual stocks. The results are similar for both, and the authors conclude that country and sector effects are the key drivers of the low-volatility effect.
They analyze performance for 1978–2012, which was characterized by a wide range of different volatility periods and investment conditions. All portfolios are assumed to be long only and unleveraged. Market capitalization of all stocks is adjusted for free float, and portfolios are re-optimized semiannually at the end of May and November, which is in line with the rebalancing schedule of the MSCI low-volatility indices. Portfolio returns are calculated monthly. The authors use the Axioma’s AX-WW 2.1 global equity factor risk model for portfolio construction from 1997. Prior to 1997, a custom multifactor risk model is used.
The authors show that using country or sector selection for low-volatility investing in global equities generates superior returns over time except during strong market rallies. The Sharpe ratio of low-volatility investing is higher when there are no constraints (e.g., sector or country neutrality) and when there are additional implementation benefits (lower turnover, higher liquidity, and better diversification).
The authors find that country and sector selection represent a good alternative to individual stock selection when capturing the benefits of low-volatility investing in global equities. The results are interesting. Although I have concerns that the data used in the analysis apply to global equities and that the findings might not always be applicable to emerging or frontier market equities, this research suggests that a low-volatility investment strategy could generate superior returns from country and sector selection. Nonetheless, despite the various advantages associated with low-volatility investing, it remains important that portfolio managers continue to pay attention to the current valuations of stocks.