A low-volatility, long-only equity strategy seeks long-term returns that equal or exceed the market with reduced absolute risk. Attractive? Let's take a look at some of the potential benefits and consequences of investing in low-volatility strategies.
Let's start by trying to answer what is seemingly an easy question: If your investment produces a 10% return, would you be pleased? It is tempting to give an automatic response of “yes,” but the reality might be somewhat different.
For example, if this investment is a traditional all-long equity portfolio, one would generally look at the relative return compared against an appropriate benchmark. This hypothetical 10% return is a wonderful outcome when the benchmark is down 5%, but not so great when the benchmark delivers a 25% return.
But what if the hypothetical investment is a true absolute-return strategy? In this case, the benchmark should be considered to be the risk-free rate, so judging the 10% return against the return of any other investment is not very relevant.*
So how do we make sense of a 10% return for a low-volatility, long-only equity strategy? Suppose the index goes up 25% in the same year. Is the hypothetical 10% return achieved by the low-volatility strategy really so bad? Low-volatility strategies, which are designed to protect on the downside, typically underperform cap-weighted indexes in big up markets, but outperform in big down markets. It is natural to lament lost opportunities; however, to concentrate on the 25% index return without acknowledging the downside risk is, in some sense, to miss the point of the low-volatility strategy altogether. Significant sell-offs are very real possibilities — during the global financial crisis, the Standard & Poor's 500 index declined approximately 50% from its October 2007 high to its March 2009 low, and took three years just to get back to even.
There is a compelling case to be made for thinking of low-volatility strategies as non-benchmark-centric. In fact, the low betas of these strategies usually make them more similar in their objectives to defensive or protective portfolios, not to mention hedge funds. Ironically, these low-volatility strategies might belong in the alternative category, as opposed to the all-long equity category. It might make even greater sense to carve out a separate category in the all-long equity space to allow for these kinds of strategies.
The cap-weighted index returns are not irrelevant, however. After all, the objective is to match or outperform an index over the long term, while lowering the absolute risk. For this to have any significance, one must consider both market returns and market risk. While short-term relative returns are likely to be confusing from the perspective of the overall performance goal, the reduced risk may well be apparent over shorter time frames and should be measured as an overall goal. Longer term, market returns could be a reasonable benchmark.
Relative-return equity strategies, which concentrate on tracking error and information ratio, are still very pertinent within the realm of equity investments. Low-volatility equity strategies have different goals and are better considered as protective or alternative strategies.