Scientific Beta: Designing more defensive solutions
By Dimitris Korovilas, Senior Product Specialist at Scientific Beta
Defensive equity solutions are popular strategies because they provide better downside protection while also delivering good risk-adjusted return due to their exposure to the low volatility risk premium.
There are two types of traditional defensive equity solutions: the factor harvesting approach, which explicitly selects low volatility stocks and weights those stocks by market capitalisation or inverse volatility, and an optimisation-based approach, which aims for the portfolio with the lowest volatility on the efficient frontier (termed the ‘minimum volatility portfolio).
Traditional defensive solutions, however, suffer from common drawbacks.
Five drawbacks of traditional defensive solutions
First, they deliver negative exposures to other rewarded factors since most providers of defensive solutions do not account for negative factor interactions.
Second, they suffer from lack of diversification as they are very often concentrated portfolios, because stocks are either weighted using inverse volatility or determined through optimisation under ad hoc constraints.
Third, they are left exposed to macroeconomic risks because they tend to have persistent sector and/or regional exposures.
Fourth, they tend to overweight low risk sectors such as Utilities, which includes companies with strong carbon intensity. As a result, their weighted average carbon intensity, or WACI, is much higher than that of the cap-weighted index.
But fifthly, and most importantly, traditional defensive indices are not always low volatility. Despite delivering lower volatility on average than their reference cap-weighted indices, they still suffer from periods of significant volatility spikes such as in October 1987 or during the financial crisis of 2008. These peaks might be undesirable for investors seeking to be defensive, not only on average, but in periods when they need it the most, namely in bad times.
iHFI Low Volatility index
For these investors, we offer a solution that combines our Narrow iHFI (High Factor Intensity) Low Volatility Diversified Multi-Strategy index (Narrow iHFI Low Volatility subsequently) with a Maximum Volatility Protection (MVP) risk control option, which addresses the drawbacks of traditional defensive strategies and is able to reduce volatility peaks.
The construction of the iHFI Low Volatility index makes use of our robust methodology for smart factor investing and includes the following important features.
First, it offers strong exposure to the Low Volatility factor, which permits investors to benefit from this factor’s rewards and defensiveness.
Second, the HFI filter implemented in the index reduces negative exposures to other long-term rewarded factors and thereby improves the long-term risk-adjusted returns and robustness of the outperformance of the index, especially when the Low Volatility factor is underperforming.
Third, the index targets the diversification of idiosyncratic unrewarded risks which helps to efficiently capture risk factor rewards.
Fourth, it employs a stock selection approach within mega-sectors and a regional neutrality construction which reduce macroeconomic risks.
Finally, a Low Carbon version of the Narrow iHFI Low Volatility index promotes a low WACI and relies on a Low Carbon filter that does not alter the performance of the defensive strategy.
MVP risk control option
The MVP risk control option is then added to the Narrow iHFI Low Volatility index to cap the volatility of the final solution at its historical volatility. Therefore, the solution is not only defensive relative to the cap-weighted index, but also in an absolute way, and investors can benefit from a product that is defensive at all times.
The MVP risk control ensures this good protection against volatility risk via a robust volatility forecasting model. The model captures stylised facts of financial returns such as volatility clustering, leverage effect and fat tails and also tackles structural breaks by using two forecasts based on an expanding window and a five-year rolling window respectively.
The dynamic defensive solution can be easily implemented via a cap-weighted (CW) futures overlay, which means that there is no additional rebalancing in the Scientific Beta Narrow iHFI Low Volatility index, but only in futures. The allocation to the CW overlay is reviewed every week and is only implemented if the change in the allocation exceeds a buffer of 20%, which limits the effective rebalancing to once per month on average.
For those institutional investors who face leverage constraints that may hinder them from using a CW overlay, there is physical implementation that employs dynamic allocation between the Scientific Beta Narrow iHFI Low Volatility index and cash.
Benefits of the dynamic defensive index
Overall, the dynamic defensive index is able to offer investors the following important benefits compared with traditional defensive strategies.
It is a defensive solution that provides much more stable volatility and significant reduction of volatility peaks during market distressed regimes, such as the financial crisis of 2008 or the recent COVID-19 crisis, compared not only to the reference cap-weighted index but also relative to traditional defensive strategies such as the MSCI Minimum Volatility index.
It is an index that has lower market betas and volatility in high volatility regimes (distressed times) compared to lower volatility regimes (good times), which makes the solution defensive when that is needed the most, and something that traditional defensive strategies such as the MSCI Minimum Volatility index are not able to capture.
It is also able to reduce downside risks considerably relative to the MSCI Minimum Volatility index, namely by 25% and 41% for the maximum drawdown and worst 5% one-year rolling volatility metrics respectively.
The reduction of volatility peaks also allows for a stronger average volatility reduction and Sharpe ratio improvement compared to the MSCI Minimum Volatility index. In fact, the reduction in average volatility is not offset on a one-to-one basis by a reduction in returns. This means that relative to the MSCI Minimum Volatility, the Sharpe ratio and volatility of the dynamic defensive solution are strongly improved by 27% and 19%, and by 35% and 22% for the Low Carbon version.
Finally, the Low Carbon version of the dynamic defensive solution is able to reduce WACI (Scope 1+2) and WACI (Scope 1+2+3) by 24% and 41% respectively compared with the reference cap-weight index, or 65% and 63% respectively relative to the MSCI Minimum Volatility index.
The dynamic defensive solution is unique in the indexing industry. It capitalises on Scientific Beta’s Smart Beta 2.0 approach to build a very robust Low Volatility index and further benefits from its capacity to forecast volatility using a robust forecasting model that takes into account usual stylised facts of financial returns such as volatility clustering, the leverage effect and fat tails.
This solution combines a Narrow iHFI Low Volatility Diversified Multi-Strategy index with Maximum Volatility Protection (MVP) risk control, which allows volatility to be smoothed through time and consequently improves average and extreme risks as well as improving the Sharpe ratio.