Equity markets – think differently! Thought Leadership Series – Series 1 of 3: Introducing the Minimum Variance strategy

The investment dogma “higher returns require higher risk” has been widely spread for decades. Indeed, equity investors have been led to believe that to achieve higher returns, taking on a relatively higher level of risk is necessary.

The positive relationship between risk and expected returns may hold true when allocating between different asset classes, but it is less valid when investing within a particular asset class such as equities.

1. Understanding a stock’s risk-return relationship

The return of an equity investment is easy to calculate. Measuring the risk of a stock however relies on several metrics with potentially different approaches. Today, volatility is considered a standard and widely accepted unit of risk. Measuring the uncertainty of a stock’s returns over time, volatility allows us to rank-order stocks within the investment universe. High-volatility stocks are then considered the riskiest and low-volatility stocks the least risky. Traditional financial theory would suggest that low-volatility stocks are less rewarding than high-volatility stocks, but this may be misleading.

Chart 1 represents the MSCI All Country World Index divided into five baskets of stocks, ranked by risk profile and their volatility and return levels over a 20-year period.

As you can see, low-risk stocks (“Quintile 1”) have actually generated the highest returns over the period, while the highest-risk stocks (“Quintile 5”) have returned the least.

KEY POINTS:

1. Equity risk is not necessarily compensated with higher return

2. Low volatility stocks tend to exceed market’s returns in the long run

3. Minimum Variance approach helps to build a diversified and adaptive portfolio with defensive qualities

*Seeyond is a brand of Natixis Asset Management.

Source: Seeyond / Bloomberg, 31 December 2016 . Q1 (lowest quintile) represents low-risk stocks based on beta. Q5 (highest quintile) represents high-risk stocks based on beta. Based on returns of stocks included in the MSCI ACWI NR USD index; Indices are unmanaged, do not incur fees, and include reinvestment of dividends and interest income, if any. It is not possible to invest in an index. Stocks are equal-weighted and quintiles are rebalanced on a quarterly basis; Risk represents the volatility of each quintile. Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future restults.

CHART 1: GLOBAL EQUITIES PER LEVEL OF RISK-RETURN (STUDY PERIOD: 01/01/1997 TO 31/12/2016)

Risk (annualised)Return (annualised)

0%

5%

10%

15%

20%

25%

30%

Quintile 5Quintile 4Quintile 3Quintile 2Quintile 1

By the Seeyond* Quantitative Research Team

This highlights the low-volatility anomaly.This anomaly has many origins, including behavioral bias: the lottery effect – small chance of a large gain; overconfidence – inconsideration for a stock’s actual risk; or the herd effect – all investors attracted by a small selection of stocks. To sum up, empirical data shows that low-risk stocks tend to generate higher returns than high-risk stocks over the long term.

2. Equity markets from a different angle

To exploit this structural inefficiency, low volatility strategies aim to provide investors with above-benchmark returns and below-benchmark risk. But to reach this goal, selecting low-volatility stocks is not enough.

Volatility shocks are more widespread and sudden than they were 20 years ago. Chart 2 below illustrates the number of weekly market swings of more than 5%.

Source : Bloomberg, Seeyond. Data as of 31/12/2016.

2

CHART2: NUMBER OF WEEKLY MARKET SWINGS OF MORE THAN 5% ON A 3Y ROLLING BASIS (1970-2016) BASED ON MSCI WORLD INDEX RETURNS.

0%

4%

8%

12%

16%

20%

Jan-

73

Jan-

77

Jan-

81

Jan-

85

Jan-

89

Jan-

93

Jan-

97

Jan-

01

Jan-

05

Jan-

09

Jan-

13

Jan-

17

All data is based on monthly observations between 31/12/1994 and 30/06/2017. Source: Seeyond, Factset. Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results. For illustrative purposes only. Indices are unmanaged, do not incur fees, and include reinvestment of dividends and interest income, if any. It is not possible to invest in an index. This should not be considered investment advice, and is not representative of any actual investment or strategy.

* Correlation is a statistic measure of the degree to which two securities move in relation to each other. Correlation is computed into what is known as the correlation coefficient.

0%

29/12

/1995

29/12

/1996

29/12

/1997

29/12

/1998

29/12

/1999

29/12

/2000

29/12

/2001

29/12

/2002

29/12

/2003

29/12

/2004

29/12

/2005

29/12

/2006

29/12

/2007

29/12

/2008

29/12

/2009

29/12

/2010

29/12

/2011

29/12

/2012

29/12

/2013

29/12

/2014

29/12

/2015

29/12

/2016

10%

20%

30%

40%

50%

60%

Median Pairwise 1Y correlation (U: MSCI Europe + Stoxx 600) 1Y Stoxx 600 Volatility

CHART 3: CORRELATION AND VOLATILITY IN THE EQUITY MARKET

Take the European stock market for example (chart 3), we can see how correlations* between stocks have evolved continuously since the late 1990s as in the chart below.

This is explained not only by the increased volatility of the underlying stocks, but also by the ever-increasing correlations in an ever more global market. Correlation measures the propensity of securities to move relative to one another across the investment universe. This concept has never been as important as it is today.

3

SEEYOND – AT GLANCE

Seeyond is the structured product and volatility management investment division of Natixis Asset Management. In order to offer investments that combine performance generation with risk reduction, Seeyond applies investment strategies that go beyond conventional active management: structured and active protected management, flexible asset allocation and active volatility management, model-driven global and European equity strategies. With 33 employees, Seeyond has $18 billion in assets under management1.

• Overview of the Seeyond Minimum Variance Investment team Nicolas Just, CFA®: Head of Strategic Equities Management,

began investment career in 1994. Juan-Sebastian Caicedo, CFA®: Senior Portfolio Manager, began

investment career in 2009.

• Overview of the Seeyond Research team Hamza Bahaji, PhD: Head of Research & Development, began

career in 2003. Stephanie Ridon: Financial Engineer, began career in 2001. Alexis Flageollet: Financial Engineer, began career in 2006

4. ConclusionAt Seeyond, we adopt a pure, unconstrained, and active approach: - pure, by focusing solely on risk minimisation - unconstrained, by no limitations of sector, country or market cap - active, by providing high active share with portfolio managers implementing a simple approach and a specific risk monitoring.

3. Seeyond’s approach to Minimum Variance

We believe the most efficient approach to Minimum Variance investing is to favor low-volatility stocks with the lowest possible correlation to one another in order to maximise the diversification of the portfolio, and in turn reduce the overall portfolio volatility. Not only does it enables us to exploit the low-volatility anomaly, but also helps to avoid correlation traps as much as possible.

This focus on managing the overall portfolio volatility seeks to provide investors with superior returns in the long run, while substancially reducing downside risk and thus presents asymmetric risk/return qualities.

NATIXIS GLOBAL ASSET MANAGEMENT – AT GLANCE

Natixis Global Asset Management serves thoughtful investment professionals worldwide through our Durable Portfolio Construction® approach: applying risk-minded insights to empower more intelligent investing. Uniting over 20 specialised investment managers globally ($951.7 billion AUM2), Natixis is ranked among the world’s largest asset management firms3.

1. Source: Natixis Asset Management as of 30 June 2017.2. Source: Natixis Global Asset Management as of 30 June 2017.3. Cerulli Quantitative Update: Global Markets 2017 ranked Natixis Global Asset

Management, S.A. as the 15th largest asset manager in the world based on assets under management ($877.1 billion) as of December 31, 2016.

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