Challenging Markowitz

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Investing nirvana may lie with lower rather than higher volatility equities, argues Michael Fraikin (pictured), fund manager for Invesco’s Pan European Structured Equity Fund.

One cornerstone of modern portfolio theory is the correlation between risk and return, the riskier an asset, the higher its returns and vice versa.

Yet Invesco’s Pan European Structured Equity fund aims to challenge precisely this premise, being based on the assumption that low volatility equities provide better returns – an investor’s paradise.

“The idea for the fund is born out of a challenge which a client posed. He asked us to develop a product which combines the prevention of downside risks with a prominent alpha creation, whilst remaining relatively independent from the benchmark. “This was something completely new; low volatility investors may have done so instinctively but never consciously,” argues Michael Fraikin, who, together with Thorsten Paarmann, manages the fund.

Launched in 2000, with the strategy being implemented since 2005, there have been plenty of opportunities to tests its resilience to volatility. “The outcome was surprising, even for us,” says Fraikin. “It completely contradicted economic theory. Since its launch we have on average outperformed the market in European equities by 5% whilst offering lower downside risks in times of crises.” Between June 2007 and September 2009, the fund had an annualised volatility (Delta) of -9.9%.

What then is his explanation for this paradox? According to Fraikin, one clue lies in the nature of volatile products. “Volatile products tend to offer high returns, but for a very short term. If we take the median return weighted against the losses, they become a lot less attractive. Markowitz is right in the short run – if you look at a time frame of a few minutes – but in the long run his assumptions are incorrect.”

“To some extent, that is a question of timing. There are periods in which volatile products tend to perform much better, which is usually immediately after an economic crash.” Indeed, to achieve returns, the period from 2009 onwards has been challenging. Like many low volatility funds, its active returns are growing relatively slowly in a normal to bullish market environment. On average, the fund had a monthly index performance of -3% in bear markets, -3% to +3% in normal markets and +3% in bull markets.

Yet timing alone does not explain how the fund distinguished itself  from other low volatility products. Another key aspect is its quant strategy. In the late 1990s, Invesco acquired Liechtenstein- based LGT Quants, and quant investing has been a cornerstone of its investment strategy ever since. Based on fundamental performance figures, the Pan European Structured Equity Fun screens a selection of 1000 stocks and targets those which combine low risk with an attractive valuation and high growth potential.

So far so good, but one common criticism of a pure quant strategy is that a pure observation of market movements and performance figures alone is insufficient to predict market movements and changes in valuation. Consequently, behavioural finance has become a key factor influencing Invesco’s quant investment strategy. “I am convinced that markets would be perfectly efficient if individuals would base their decisions precisely on these risk-return expectations.
Unfortunately, that is not the case, individuals tend to make mistakes which are predictable,” argues Fraikin. Consequently, behavioural finance theory serves as a guideline to analyse changes in valuation and pricing.

In the current climate of apparent economic recovery, the need for a low volatility fund remains less obvious. “A lot of our investors remain sceptical. People don’t fundamentally trust Draghi’s policies so far, but at the same time they do want to benefit from the recovery. In such an environment, where bull markets are all but certain, the fund offers a perfect solution,” he concludes.

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