Return Generation
One of the more compelling arguments for investing in an active low volatility strategy is the ability of an active manager to infuse return forecasts into the portfolio construction process. In fact, the passively managed minimum variance portfolio, which selects stocks solely based on their squared standard deviation, takes the extreme and naïve view that every stock has the same expected return. In contrast, an active manager can favor stocks with higher expected returns.

Our research suggests adding a return expectation to a low volatility strategy potentially increases returns by enhancing the upside capture with little to no impact on downside capture—and with little to no impact on overall portfolio risk.

Adaptive Process
A final consideration is whether a low volatility strategy can adapt to changing market conditions. By definition, passive low volatility strategies follow rigid and predetermined portfolio construction techniques. In contrast, an active low volatility manager has the flexibility to adapt the portfolio as market conditions warrant. For example:

  • Changing market risks: An active manager has the flexibility to observe changes in the market and reprioritize to focus on the most important risks, while passive strategies rely on the same measure of risk regardless of its expected importance in the current market. Sometimes these risks will be captured by risk forecasts, but sometimes they will not. For example, in 2013 interest rate risk increased rapidly during the “taper tantrum.” Many fundamental risk models do not account for interest rates, and historical volatility did not identify this risk.
  • Rebalance frequency: An active manager has the flexibility to monitor risk and rebalance the portfolio whenever necessary, while passive strategies follow a predetermined schedule, often reassessing the portfolio’s risk only once or twice a year. This flexibility is likely to be most valuable in highly volatile markets — when the low volatility portfolio is expected to deliver the greatest benefit.
    For passive strategies with regularly scheduled rebalancing, their inflexibility also means portfolios become increasingly risky as the calendar progresses, only to be rebalanced at an arbitrary point in time.
  • Trade off risk and return: One of the key advantages active managers have over passive low volatility indexes is the flexibility to trade off risk and return decisions over time. That is, managers can focus on risk reduction during periods of higher volatility, while offering more return generation during periods of lower volatility.

Over the long term, smart adaptability should benefit both the upside and downside capture ratios of a low volatility portfolio.