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Fund Focus - QVFD

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Investors have traditionally used low volatility strategies to seek improved risk-adjusted returns relative to the bench­mark by aiming to reasonably participate in market’s growth while seeking to mitigate downside risk.

The challenge for investors looking to invest efficiently in low volatility portfolios is that while obtaining low volatility exposures, other risks can get introduced into the strategy. Oftentimes, a low volatility strategy can have significant overweight’s to sectors such as utilities or consumer staples that tend to have lower volatility and significant underweights to sectors such as information technology and communication services. Similar biases can happen at regional level.

These sector and regional exposures can lead to introduction of interest rate risk or worsen the carbon footprint of a low volatility portfolio.

Another significant risk that can impact a low volatility strategy is its sole reliance on historical volatility to predict a company’s future volatility. In a market where sudden spikes in volatility is becoming the norm rather than exception, this is a major issue as there is no certainty that something with low volatility in past will continue to show this behavior in future.

We believe that it is essential for low volatility strategies to have a foundation based on a company’s fundamentals.

In this paper, we offer a closer look at how investing in high quality stocks with favorable sustainability characteristics, while controlling for sector, region and stock specific risks can offer potential for improved risk-adjusted returns in a low volatility strategy.

We then explain the proprietary methodology that Northern Trust Global Investments Limited use to assemble an index of high-quality, low-volatility companies that have favorable sustainability profiles and a reduced carbon footprint.

THE CHALLENGE OF FINDING STOCKS THAT CAN MAINTAIN LOWER VOLATILITY

Investors often seek ways to minimize short-term fluctuations in their portfolios as they pursue long-term gains. One popular approach is to assemble a portfolio of stocks with lower volatility than the overall market, with the goal of reducing potential downside risk in exchange for giving up some upside potential during positive markets. The objective of a low volatility investor is to give up less of the upside relative to the protection achieved on downside and compound this differ­ence over time to not only reduce risk but also enhance returns.

For mitigating the downside, a low volatility strategy needs to have its constituents to persist with their low volatility characteristics, during period of market stress whereas in order to improve its participation in upside, the strategy needs its constituents to have strong fundamentals that can lead to improvement in returns.

Faced with these objectives, we believe that investors can enhance their low volatility strategies by carefully investing in low volatility stocks that are high quality and have favorable sustainability characteristics.

Our research suggests higher-quality companies with stable profitability, strong cash flows and prudent management tend to enhance the stability characteristics of a low volatility portfolio.

As shown in the chart below, within the lowest volatility quintile of the global developed universe, lowest quality stocks tend to have the lowest returns and highest realized volatility. For this reason, we believe that a low volatility strategy that integrates quality may be better positioned to avoid stocks that are not likely to have lower volatility in future. This should help improve both the upside participation and downside mitigation characteristics of the strategy.

In a similar vein, companies that show leadership on sustainability issues tend to be better at managing the risks and opportunities arising from environmental, social and governance themes such as physical climate risk, climate transition risk and regulatory risk.

Effective management of these risks may create avenues for stable revenue and profitability for companies and may protect them from significant drawdowns in their equity value.

CONTROLLING FOR UNREWARDED RISKS IN LOW VOLATILITY STRATEGIES

We believe that while investing in low volatility strategies, investors should avoid unrewarded risks that can add to volatility of the strategy. If a low volatility strategy is not properly designed such risks can impact both returns and risk of a low volatility strategy.

Low volatility strategies available in the market tend to perform well when interest rates fall and perform poorly when they increase. Although this behavior is driven by sector exposures of low volatility strategies rather than factor exposure. Certain sectors like utilities and consumer staples tend to have relatively lower volatility as well as higher sensitivity to interest rates. A low volatility portfolio that does not control for such exposures brings in unwanted macro-economic risk in a low volatility strategy that is not additive to the returns.

Further, as utilities tend to have a significantly high carbon footprint in any bench­mark universe, this leads to a low volatility strategy being exposed to climate risks. As an example, utilities contribute to nearly 45% of carbon footprint in a global developed universe while only having a 3-4% weight in the universe. Again, if the strategy is poorly designed, this exposure can expose the portfolio to climate risks as well as make it unsuitable to meet the objectives of an investor.

FLEXSHARES SOLUTION: USING QUALITY, SUSTAINABILITY, RISK AND RETURN TO ACCESS POTENTIAL FUTURE VOLATILITY

The FlexShares Developed Markets Low Volatility Climate ESG UCITS ETF intends to invest in high quality stocks that possess potentially lower overall absolute volatility, while avoiding unintended sector, region and style biases.

The Fund tracks the iSTOXX® Northern Trust Developed Markets Low Volatility Climate ESG Index. Northern Trust Global Investments Limited (NTGIL) is the investment manager for FlexShares ETFs. The underlying index is focused on mitigating downside risk while maintaining a reasonable upside potential. It does so by combining a proprietary view of quality along with a holistic approach to sustainability to help have a forward-looking view of volatility, and by applying sector and region constraints to avoid unintended concentrations.

Starting with the STOXX Global 1800 Index , NTGIL first applies a sustainability screen to exclude companies for violations of international norms around environ­mental, social and governance issues, along with those involved in controversial business lines such as weapons, tobacco and thermal coal.

Working within this screened universe, NTGIL then applies the proprietary Northern Trust Quality Factor to derive a score that we believe measures a company’s core financial health and helps evaluate whether it has the stability in its volatility and correlation characteristics.

NTGIL evaluates companies in each sector and region across these lenses to calculate each company’s relative quality score. We believe this methodology helps to substantiate an “apples-to-apples” comparison and supports diversifica­tion in the index construction process. Then, the stocks in each sector and region are divided into quintiles, with quintile 1 comprising companies with the highest quality scores and quintile 5 comprising companies with the lowest quality scores.

The index eliminates all stocks in quintile 5 (subject to stock level bounds) and then NTGI applies its proprietary sustainability scoring methodology to the remaining stocks. This methodology includes:

NTGIL then constructs a minimum variance optimization portfolio with the intention of reducing the portfolio volatility relative to the benchmark while maximizing quality and improving sustainability scores and climate characteristics.

The index also uses constraints to maintain sector and region neutrality with the STOXX Global 1800 Index. We believe this approach helps balance risk and return, while also reducing turnover and transaction costs.

Through quarterly rebalancing, NTGIL aims to help maintain the index’s lower volatility and high quality while maintaining its sustainability profile. Regular rebalancing is also expected to help maintain the index’s expected risk and return profile.

CONCLUSION

In designing low volatility strategies, we focus on risks that we are getting paid to take through low volatility and quality factors. We aim to avoid unintended sector exposures that add to risk without adding to return.

We also intend to have the portfolio to integrate a holistic view of sustainability to help it meets investors ESG and climate objective as well as to protect it from associated risks.

A strategy constructed with this in mind is well positioned for strong up-market capture while mitigating losses during market drawdowns.

The FlexShares Developed Markets Low Volatility Climate ESG UCITS ETF applies these principles and offers a quantitative, repeatable methodology for pursuing an investing strategy that emphasizes downside protection while maintaining upside potential.


FIND OUT MORE

The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for professional investors. If you would like to learn more about the attributes of any of the ETFs discussed in this report in greater depth or the index methodology behind them, please send an email to EMEA_FlexShares@ntrs.com.