Low volatility equity strategies have become an increasingly popular solution in the investor toolbox. This is largely the result of an increasing awareness of the low volatility anomaly, a growing use of lower volatility seeking smart-beta strategies, and a greater appreciation of the damage caused by large portfolio drawdowns.
These strategies have become an important option in smart-beta investing because they seek three key objectives: reducing the overall risk/beta of the portfolio, providing significant downside protection, and retaining meaningful upside participation.
As many investors take a closer look at low volatility strategies, an important question is whether to choose an actively managed or passive approach. To answer this question, we believe low volatility investors should focus on three criteria:
- Risk reduction
- Return generation potential
- Adaptability (or lack thereof) of the investment process
In this paper, we’ll explore these criteria and make the case for choosing an actively managed approach.
Evaluating A Low Volatility Strategy
Risk Reduction
We believe the top priority of any low volatility strategy is to deliver lower portfolio risk relative to the cap-weighted benchmark. Strong risk reduction also leads to a compounding benefit, or lower “variance drag,” which is key to low volatility’s potential outperformance in the long run.
Reducing portfolio risk requires forecasting the potential future volatility of individual equities as well as all pairwise correlations among them. Risk forecasts can be thought of along two dimensions:
- Single vs. multiple: Using one or more measures to forecast risk.
- Simple vs. sophisticated: Using estimates ranging from simple trailing volatility calculations to increasingly complex, multifactor models.
Risk Measures: Single Or Multiple?
Passive low volatility options often rely on only a single measure to assess risk. Active managers can measure risk in several ways, using different techniques; doing so provides a more robust, diversified view of risk that may result in lower realized volatility. We believe this gives managers a greater chance of identifying emerging risks in the market.
For example, a 50-stock portfolio based solely on trailing 1-year price volatility as of December 31, 2014 would include a 40% weight in Real Estate Investment Trusts (REITs). While each REIT may individually be low risk, this portfolio ends up quite concentrated, introducing an easily identifiable risk.
Risk Measures: Simple Or Sophisticated?
Sophisticated approaches often use complex, multifactor risk models that consider underlying drivers of risk. These models also use correlation estimates when determining stock weights, as adding stocks with low or negative correlation to a portfolio reduces overall risk regardless of that stock’s standalone risk.
We believe managers who use a more sophisticated approach are typically better equipped to manage correlations during portfolio construction and are better able to deliver a low risk portfolio. Going back to our 40% REIT portfolio example, we can consider two additional low volatility portfolios that use more robust risk forecasting techniques.
- Starting with the same Russell 1000 universe, we built a low volatility portfolio by minimizing total portfolio risk as measured by a fundamental multifactor risk model, which includes correlation estimates. This portfolio cuts the weight in REITs to 20% of the portfolio.
- A second, more robust portfolio could be constructed by also including a macroeconomic risk model, as REITs contain significant interest rate exposure. A portfolio that considers both the fundamental and macroeconomic risk models further reduces the weight of REITs to only 10%.
As these examples demonstrate, there are many different ways to build low volatility portfolios, and the choices made in portfolio construction can lead to significantly different portfolios.
Finally, since an investor in a low volatility strategy recognizes (implicitly at least) that market-cap-weighted benchmarks are not efficient, any portfolio construction parameter that tilts a low volatility portfolio back toward market cap weighting dilutes the low volatility nature of the portfolio and increases expected risk.
We believe less constrained low volatility strategies should deliver lower risk and more attractive diversification, and thus should be favored by investors.