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Low Volatility Strategies: Tech Momentum Heightens Risk

Brett Turenchalk Associate, Client Analytics

In this latest addition to our blog, we examine the shifting risk profiles of two passive low volatility strategies.

Don’t look for the needle in the haystack. Just buy the haystack.

– John Bogle, Vanguard

When making passive investments, especially those run by systematic strategies, investors should watch for sparks that could light the haystack on fire.

Over the last two years, Tech stocks—with FAANG at the helm—have attracted more and more capital from hedge funds, momentum traders, and retail investors alike. Steady Tech performance has resulted in low volatility (low-vol) and larger tech weightings by low-vol strategies. This phenomenon was covered by the financial press throughout the year. Using Novus’ risk tools, we’ll highlight how these increased Tech allocations have changed the risk profiles of certain low-vol indices.

Tech Sector Trends

After a slight correction in June, the Tech sector continued its stable ascent and outperformance of the broader market.

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This methodical upward performance pushed the sector’s volatility to a five-year low.

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Low Volatility Strategies

It’s no surprise that Utilities and other non-cyclicals have been the predominant sectors in low volatility indices during the past five years. Looking at the PowerShares S&P 500 Low Volatility ETF [SPLV] as an example, 40% on average was invested in Utilities and Consumer Staples from 2013–2016.

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The index, which is constructed using trailing twelve-month volatility, saw a large uptick in Technology and Telecom exposure in 2017. The chart below shows these rising from roughly 5% of the fund in 2016 to nearly 14% of the fund through September.

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On a market beta adjusted basis, Tech’s weight is even more pronounced at 21% of the portfolio. Here are the Tech names that were added YTD:

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Another major low-vol fund is the iShares Edge MSCI Min Vol USA ETF [USMV]. MSCI takes the index construction a step further. They optimize at the portfolio level and apply a minimum-variance strategy to mid and large-cap US equities. This method also led to increased Tech exposure—from 15% in 2016 to 19% through September. Names bought include Dell, Facebook, IBM, Microsoft, Adobe, VMWare, Oracle, and Salesforce.

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On a market beta adjusted basis, Tech’s portfolio weight is at a historical high of 32%.

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Research Affiliates published a study on the construction of low-vol indices that highlights the systematic tendency toward industry concentration, as we’ve seen with Utilities and more recently Tech.

Risk Profile and Factor Scenarios

To illustrate Tech’s higher long-term volatility profile, we’ve charted the volatility across multiple rolling periods, beginning with twelve months on the left and ending with sixty months on the right.

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Over the last five years, both the Powershares and MSCI indices had similar trailing five-year volatility at roughly 9% annualized, while Tech had 13% annualized volatility.

When Tech stumbles, the sector will likely introduce higher volatility (and dispersion) into these indices than investors are historically accustomed to. Below we created a simulated factor scenario based on a 20% market drawdown. We allowed the VIX to react as it did historically, as well as the traditional Fama-French style factors size, value, momentum, and lastly crude oil. We excluded the impact of our yield curve and precious metals factors.

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Using the Sep 2016 holdings of the PowerShares S&P 500 Low Volatility Index (pre-Tech additions), the model predicts a 10% drawdown for the portfolio. Using the Index’s Sep 2017 holdings (with Tech additions) in the same factor scenario, the model predicts a 15% drawdown given the same 20% market drawdown.

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Other Risks

Another risk is the increasing exposure to crowded hedge fund securities over the last year. The weighted average crowdedness score of the PowerShares low-vol index is now at a similar level as the S&P 500 (which has double the Tech weighting). Our research has found that equities with many hedge funds invested (who control a large percent of the daily liquidity) may experience greater selling pressure in a drawdown compared to uncrowded names.

Finally, the addition of Tech has caused a substantial market cap shift in the PowerShares low-vol index: it now has a much higher mega-cap portfolio weight compared to the last five years. This has also driven the portfolio’s size factor beta further negative.

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Takeaway

The above portfolio shifts suggest there is a real need for investors to actively monitor passive investments, especially those that are systematic, as algorithmic changes to these strategies may introduce unintended outcomes.

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