Empirical evidence from historical equity performance suggests that risk is not properly rewarded. Research1 shows that if an equity portfolio is constructed with as little risk as possible, it would be reasonable to expect to earn approximately the same return as with the traditional capitalization-weighted stock market index (over full market cycles) while taking on only 2/3 of the risk.

This was the foundation of the idea behind low volatility strategies. Since the first low volatility portfolios were created in 2006, there has been tremendous buy-in from the investment community. Assets under management have accumulated at a staggering pace, with institutional assets exceeding $300 billion2. Once retail assets are factored in, some industry experts claim that low volatility equity equities could be as much as US$900 billion.

Today’s noise

The popularity of low volatility equities, however, has alarmed some investors who have begun to voice criticisms over the low volatility strategies, stating that they may now constitute an over-crowded area of the stock market. These criticisms can be bucketed into three main areas:

1. Low volatility equity strategies have “outperformed” up to now and should be expected to underperform moving forward.2. The popularity of low volatility equities has inflated their prices and they are now “expensive.”3. Low volatility equities will perform poorly as interest rates eventually rise.

This article will take a deeper dive into these concerns and will illustrate that there is little evidence to back these claims.

Muting the noise around low volatility equity strategies

N E W T H I N K I N G

1Yuriy Bodjov and Isaac Lemprière, A Review of the Historical Return-Volatility Relationship, May 2015.2All Low Volatility Equity Universe from eVest Alliance. As of September 30, 2016.

New Thinking | Muting the noise around low volatility equity strategies PAGE 2

Critisism #1: Low volatility equities are due to underperform

The fundamental assumption with low volatility equities is that they are expected to perform better during crises and underperform during strong recoveries. So, should it really be a surprise that they have been outperforming over the past decade? Moreover, does this mean we should now expect underperformance?

The past decade has witnessed a series of major market events, including the:

• 2008/2009 global financial crisis

• 2011 European debt crisis

• 2015/2016 commodity crisis

During this time, equity performance was dramatically impacted by long periods of high volatility. The graph above shows the cumulative value of C$100 invested at the end of 2007. The dark line indicates that $100 invested in the capitalization-weighted MSCI All Country World Index would have provided a modest return of 3.2% per year. The same initial amount invested in the MSCI ACWI Minimum Volatility Index would have had a return of 7%.

A market where there are wild swings in performance should bode well for low volatility equity strategies by the nature of the strategy, and the significant out-performance of low volatility equities over the past decade actually meets expectations formed from analyses of prior market cycles. The only difference, which is where the misconception of “over performance” is born, is that we have simply not witnessed a fully balanced market cycle, yet.

Criticism #2: Low volatility stocks are currently overvalued

Critics of the low volatility equity strategy have stated that the demand for low volatility equities has inflated stock values and now deem them “expensive.” At a basic level, it seems like a legitimate argument. However, is it fair to say that a stock is overvalued only by looking at a key ratio in isolation? Or to judge it by the ratio irrespective of a comparative benchmark?

Analysts utilize numerous ratios, including the price-to-book, the price-to-historical earnings, and the price-to-consensus of forward earnings in order to properly assess the expensiveness of a stock. Naturally, higher ratios would indicate they could be overvalued. Using these popular ratios, let’s see if low volatility equities are, in fact, expensive.

At the end of September, the MSCI All Country World Index was selling at 2.1 times book value. The MSCI ACWI Minimum Volatility Index and the TD Emerald Low Volatility All World Equity PFT were both selling at 2.7 and 2.2 times book values, respectively. On the basis of market price to accounting book value, there are no significant differences between the traditional benchmark, the minimum volatility benchmark, and the TD Emerald Fund. Moreover, the MSCI All Country World Index was selling at 21.3 times trailing earnings, only slightly lower than the multiple for the MSCI ACWI Minimum Volatility Index (21.9) and actually higher than for the TD Emerald Low Volatility All World Equity PFT (20.4).

Thus, low volatility equities can actually be considered cheaper than the traditional index in terms of trailing earnings. The market price-to-consensus of forward earnings multiple also places the traditional index somewhere between the Minimum Volatility Index and the TD Fund in terms of valuations. These three popular multiples provide no significant evidence to conclude that low volatility stocks are currently overvalued.

Performance reviewMarket environment favorable to low volatility strategies

Source: MSCI Inc. As of September 30, 2016. All returns on the MSCI All Country World Indices are gross of fees and in U.S. dollars.

Euro Debt CrisisOct'11

Taper TantrumJun'13

China, Greece, OilEM weaknessJun'15-Dec'15

Financial CrisisAug'08-Mar'09

IndexPrice to Book Value

Price to Trailing Earnings

Price to Forward Earnings

MSCI AC World Index 2.1 21.3 17.0

MSCI ACWI Minimum Volatility Index

2.7 21.9 19.2

TD Emerald Low Volatility All World Equity PFT

2.2 20.4 15.7

Sources: Bloomberg Finance L.P., TDAM. As of September 30, 2016.

Multiples comparison

New Thinking | Muting the noise around low volatility equity strategies PAGE 3

Criticism #3: Low volatility stocks are negatively correlated to interest rate movements

The third criticism is that low volatility equities will perform poorly in a rising interest rate environment. Low volatility equities typically have higher dividend yields, and as such, have become a substitute for bonds. Their popularity over the past decade is due in part to falling interest rates. However, today the perception is that as interest rates eventually rise, investors will leave higher dividend payers and return to bonds, leading to poor performance of low volatility equities.

But is this negative correlation actually true? Our research has shown that based on the behavior of low volatility and high volatility equities, this negative correlation is not true over the long term.

The graph below illustrates the excess return of the quintile of large-cap U.S. equities with the lowest volatility vs. the quintile of large-cap U.S. equities with the highest volatility and charts it next to the 10-year U.S. Treasury yield. The positive shaded areas correspond to periods during which low volatility equities outperformed high volatility equities. The negative shaded areas correspond to periods during

which volatile stocks outperformed less volatile stocks. From late 1953 through mid-1981, less volatile equities outperformed 68% of the time. From mid-1981 through late 2016, low volatility equities outperformed 79% of the time.3

While some equities are more sensitive to changes in interest rates than others, historical evidence suggests that there has not been a strong correlation between the direction of interest rates and the relative performance of low volatility vs. high volatility equites. However, there is a high correlation between the strength and direction of equity markets; namely, low volatility equities tend to outperform in bear markets and to underperform in strong market recoveries.

Changing with the timesThe sources of risk and volatility change over time. What’s important to keep in mind is that different sources of risk will be associated with changing volatility patterns. Moving forward, the successful low volatility portfolios will be the ones that can anticipate and adapt to the changing sources of risk, adjusting their portfolios accordingly.

Correlation analysisThere does not appear to be a correlation to interest rates

Source: Isaac Lemprière and Yuriy Bodjov, Low Volatility Strategies: The Historical Performance, Canadian Investment Review, May 19, 2015.

3This includes the excess return of the 100 least volatile stocks minus the 100 most volatile stocks (chosen on the basis of a trailing 60 month return volatility basis from among the 500 largest U.S. stocks. These portfolios are equally-weighted. A low volatility portfolio would also use correlations to select stocks and would not be equally weighted.

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