Doing the math on low-volatility strategies

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.

Lowering investment risk has many benefits. One such benefit that isn't always fully appreciated is that lower risk leads to a greater likelihood of achieving return objectives in a shorter time.

Here's an example: Plan Sponsor A invests $100 million in a high-volatility index portfolio that returns 25% in 2010, making it worth $125 million at year end. In 2011, it declines 20%, resulting in a two-year net return of 0%.

Plan Sponsor B, whose goal is to protect its investment in the event of a significant market sell-off, invests in a lower-volatility absolute-return-oriented portfolio. The portfolio goes up 7.5% in 2010 ending the year with a value of $107.5 million. While Plan Sponsor B might regret not investing in the high-volatility portfolio that returned 25%, it's important to remember that the goal was to protect its investment. In 2011, while Plan Sponsor A's investment declined by 20%, Plan Sponsor B's investment lost just a bit less than 7%. Plan Sponsor B had only $107.5 million at the end of 2010; however, like Plan Sponsor A, Plan Sponsor B's investment returns to its initial $100 million in 2011.

If Plan Sponsors A and B had both begun investing in their respective portfolios at the start of 2011, the outcome would be different. Plan Sponsor A would have had to do very well to recover from the 20% loss experienced in 2011. A 25% return for the portfolio in 2012 would go a long way; however, this is not the expected outcome. High volatility doesn't mean that performance is always highly positive or negative; it simply means the spread of likely outcomes is wider. If Plan Sponsor A's strategy does well over time, it could take years to recover.

Plan Sponsor B is in a much better position, with the probability of recovering much more quickly and perhaps having a fighting chance of meeting its short-term goals during the recovery period.

Even though Plan Sponsor B started investing at an inopportune time, it most likely won't be hurt for poor timing as much as Plan Sponsor A will.

The ideal scenario would have been to choose the high-volatility portfolio in 2010 and then switch to the low-volatility portfolio in 2011. However, timing entries and exits is very difficult.

So rather than having to depend on luck, selecting a low-volatility strategy could provide a better outcome — achieving a return objective in a shorter expected time.

Low-volatility portfolios offer a number of benefits to institutional investors, making this type of strategy particularly attractive:

• Low-volatility portfolios offer a better risk-return trade-off than traditional long-only strategies, as evidenced by higher Sharpe ratios over time.


• While some of the upside in the short term might be sacrificed, low-volatility strategies offer the opportunity to meet or even exceed cap-weighted index returns over time at substantially lower volatility levels.


• Low-volatility strategies provide greater downside protection with the potential for equity-like returns.


• These strategies have the potential to achieve their return objectives sooner and in a smoother fashion than higher-volatility strategies.

In summary, given the high levels of volatility that have defined the equity markets over the past few years, a low-volatility investment approach might be a viable approach for plan sponsors seeking market-like or above-market returns with less volatility and risk.

Offered the choice between two absolute-return strategies with the same long-term expected outcome, select the strategy with lower volatility, because it is more likely to get to the end goal in a shorter time horizon.

*Since the risk-free rate is the true benchmark, not zero, the term “absolute” throughout this article should be regarded as “relative to the risk-free rate.” The term “relative” will always indicate that returns should be measured against an index benchmark.