Spooked by macroeconomic uncertainty, the past five years have seen investors find increasingly inventive ways to avoid equity market volatility. From the advent of absolute return funds, through to minimum variance, low volatility or VIX-related exchange-traded funds, strategies that seek to minimise the ebb and flow of stock market pricing have found resonance.

The first quarter of 2016, for example, saw record inflows into risk-based ETFs such as minimum volatility. Lyxor ETF research found that the sector attracted €1.2bn ($1.35bn) of the €2bn that flowed into smart beta ETFs over the quarter. This has persisted into the second quarter, with minimum volatility strategies seeing inflows of €399m in May, the highest ever in a single month.

The absolute return sector has also been consistently strong. It was the best-selling Investment Management Association (IMA) sector in May and the second best selling in June, as investors sought lower volatility options in the run-up to Brexit. Equally, ETFs based on volatility indices, such as the VIX (based on the implied volatility in the S&P 500 index) and the VSTOXX indices (based on the implied volatility in the EURO STOXX 50) have been brought to market in Europe and have proved popular with investors.

Institutional investors particularly are increasingly operating with either an implicit risk budget or explicit risk target. Risk-targeted funds in particular have become increasingly popular in the wake of regulatory change and investor suitability requirements. For these managers, targeting lower volatility equity options gives them a higher risk budget to spend elsewhere. At a time when investors are increasingly been pushed up the risk scale by central bank policy, having volatility budget to spare while retaining access to stock market growth has proved attractive.

Absolute return funds

The investment industry’s first response to the clamour for lower volatility products was absolute return funds. Many of these aimed to target equity market-like returns with around half the volatility, by harnessing pure alpha. There is still considerable debate on whether these funds have achieved their goals.

In general – and the sector is diverse – many have been better at avoiding volatility than generating real returns. Within the IMA Targeted Absolute Return sector only 8 out of 75 funds have a volatility higher than 10, according to Financial Express data. There is only one fund out of 240 in the IMA Global Equity sector with volatility below 10.

However, this has come at the expense of returns. The five-year average return for the absolute return sector is just 16.6%, while that of the global equity sector is 77.4%. While this is perhaps an unfair comparison, given the unusual strength of equity markets over the past five years, it does raise the question of whether the pursuit of low volatility is compromising long-term returns in the sector.

Indeed, funds in the absolute return sector are up just 0.7% year-to-date. In spite of all the volatility since the start of the year, investors would have generated returns of 17.4% in the average global equity fund.

The ETF option is a relatively new choice for managing volatility, but has proved a more successful option. “There are two broad classes of product,” says Chris Riley, investment research manager at RSMR. “One type builds a portfolio of those stocks that have had the lowest volatility in the past. It is based on that simple process – that what has worked in the past will continue to show lower volatility in the future.” He adds that the returns from these products have been relatively good and a lot of capital has flowed into that area.

“The second main type of product is rarer. For these the provider looks to structure a portfolio of the lowest volatility stocks, but to take the correlation of stocks into account. This means not just buying stocks with the lowest correlation, but may include some higher volatility stocks that have good correlation properties with other stocks to bring the overall volatility of a portfolio down.”

Within the first option, there is a range of approaches. A number of new participants have entered the market so the choice for investors is broad. Significant players in the sector include iShares, Lyxor and Ossium. Some simply take the index and over or underweight stocks according to their historic volatility. There are ETFs covering most of the major indices. Others will operate a fully unconstrained option, excluding or shorting higher volatility stocks. Riley says that shorting higher volatility stocks has been more powerful for returns in back-testing, though it may introduce other risks.

Returns have been good because many of the lowest volatility stocks have been popular with investors over recent years. Stable businesses, with stable revenue and cash flow have been highly prized. But this may also suggest a future problem for minimum or low volatility ETFs.

Charles Aram, head of EMEA at Research Affiliates, says: “If you overpay, no matter what the quality of the asset, you will get a poor investment result. Minimum variance strategies have been very successful, but I would point to rising valuation multiples. In 2002, low volatility stocks had a valuation multiple considerably lower than the wider market. It is now somewhat higher. In other words, the stocks in these strategies are now much more expensive than the general market. The worry is that while these strategies might still deliver low volatility, you can’t expect high returns. Valuation does matter.”

Value of volatility

The VIX indices also have their limitations. In theory, investors should receive protection against volatility, because their investment rises as volatility rises. However, VIX ETFs don’t hold the actual VIX, which is simply a calculation, but instead track futures on the VIX index. While they do this accurately, VIX futures are not a perfect proxy.

Equally, it should be said, volatility is not that high relative to historical levels so these strategies haven’t made a great deal of money. The path of the VIX index shows that volatility now is around a quarter of the level seen at the height of the financial crisis. At its peak at the end of 2008, the index level reached 80. Even at the height of the market panic at the start of this year, the index only hit 26.

It is a similar picture in European markets. This also peaked out in October 2008 (at 71) and has never subsequently reached similar heights. The closest it came was in September 2011, but this year it hasn’t got above 40 and is down 21.62% over the past 52 weeks (STOXX to 12 August).

There is perhaps a more fundamental question: should investors really be avoiding volatility? Are investors paying too a high price to protect against volatility that isn’t really that high and should anyway be part and parcel of investing?

“What is driving an investor to avoid volatility?” questions Gary Potter, co-head of F&C multi-manager solutions at BMO Global Asset Management. “Is it because they are scared of risk? Is this off-benchmark risk? The key is really to have enough time to embrace risk. Investors need, to some extent, to accept that volatility is what gives you the returns. There is a perception that avoiding volatility is somehow a good thing. I would point out that there are only three areas that have struggled for the year to date and one of them is absolute return.”

Certainly, a distinction should be made between long and short-term volatility. Avoiding volatility at all costs, and over the very short term, has proved a poor strategy for investors over the past five years. The best strategy has been to retain market exposure but focus on stocks with historically low volatility but, going forward, this approach has inherent dangers as this type of stock trades at high valuations. Investors may find that minimising volatility comes at an increasingly elevated cost. G