Low Volatility Equities
The objective of the strategy is to optimize the risk-adjusted return compared to the global equity market (MSCI AC World) – i.e. to have a higher Sharpe ratio – by investing in 80-120 companies with low share price volatility and high fundamental quality. Due to the lower risk of the strategy, we expect lower drawdowns than the global equity market in down markets.
The basis of our investment philosophy is the recognition that the financial markets are characterized by anomalies that we through active investment management can exploit to create an attractive risk-adjusted excess return over time.
Academic literature – i.e. the CAPM model's so-called security market line – indicates that there should be a positive linear correlation between the risk (beta) of a share and the expected return over a given horizon. If equity markets are efficient, different levels of risk should be the only explanation of variances in expected return. However, in the early 1970s when the theory was first tested empirically in the US equity market, it became clear that the risk-adjusted return for equities with a low systematic risk (beta) was higher than predicted – see for instance Black, Jensen & Scholes (1972), Fama & MacBeth (1973) and Haugen & Heins (1975). In other words, low risk companies on average generate a higher return than explained by their corresponding risk.
In recent decades, several new studies have been published – analysing various time periods and various geographical markets – which, based on varying measurements of risk, verify that investors have not been rewarded with higher long-term return for taking risks. Our philosophy is to capture this inefficiency – or anomaly – by investing in companies with low share price volatility and high fundamental quality, meaning companies with a healthy and proven business model and high return on invested capital, low earnings variability and low financial leverage. The fact that the low-risk anomaly is based on a number of systemic and behavioural sources strengthens our belief that it will persist in the future.
We practice active portfolio management based on consistent and systematic investment processes. The combination of quantitative modelling and qualitative assessment in a disciplined bottom-up process is the basis for the selection of the equities in our portfolios. Teamwork ensures that the competencies of our specialists are fully utilized and that our investment decisions are always well-founded.
Our investment process has been structured in four general work phases with quantitative and qualitative elements – definition of universe, ideas generation, analysis and portfolio construction.
A quantitative screening establishes a universe of equities with low share price volatility. We eliminate the 50% most volatile equities, as we want to invest only in the part of the equity market with lowest volatility. At the same time, we eliminate the least liquid equities (< DKK 50 million in daily trading volume) as low volatility may simply reflect illiquidity.
We generate ideas in different ways. One important source is our proprietary screening model consisting of several factors based on quality, value and momentum metrics. The output from the model is a comprehensive list of potential candidates appearing attractive on different metrics. We also generate ideas from research, conferences, talking to external analysts, etc.
We perform an in-depth fundamental analysis of the best ideas. In the search for companies with high fundamental quality we focus especially on companies with economic moat – i.e. companies with a lasting competitive advantage that allows the company to generate excess economic profit for an extended period compared with no moat companies. At the same time, we focus on not overpaying for the companies' characteristics – equities with low volatility in companies with high quality. We apply a broad spectrum of value indicators, including absolute valuation like DCF value and relative valuation where we look at different multiples compared to history, the market and the peer group. Risk analysis is an integrated part of our evaluation of a company’s attractiveness – we focus especially on items that have the potential to disrupt the share price stability.
The objective is to construct a portfolio with a lower expected risk – measured by the standard deviation –than the global equity market under the constraint of a maximum of 30% invested in a single sector (MSCI GICS Level I). The portfolio construction consists of quantitative input and qualitative assessment. The quantitative input being an optimization in a multi-factor risk model in order to minimize the total risk of the portfolio under a simultaneous maximization of the return potential. The qualitative assessment includes elements such as the strength of the investment case, the uniqueness of the company compared to existing companies in the portfolio, company-specific risks including potential binary events and finally the liquidity of the equity.