Derisking solutions: low and managed volatility

Equity market turbulence is a term we've become all too familiar with in 2016.

Continued volatility in global markets has sparked meteoric interest in low-volatility equity strategies, portfolios constructed mostly based on estimates of volatility rather than returns, enabling investors to reduce market drawdown and improve performance efficiency. Assets invested in low-volatility equity strategies have grown by 46% a year since December 2010.

Investors continue to face the quandary of wanting to invest in equities, as it is a core return-generating asset class, but don't want the potential volatility risk with which it is associated.

Is it possible to meaningfully lower the absolute risk of investing in equities without sacrificing returns? The short answer is yes, through low-volatility investing.

Low-volatility investing provides risk reduction to investors without sacrificing the growth potential of equities. For plan sponsors, this allows for reducing total risk by lowering the volatility of return-generating assets within the overall plan, while meeting funding-status and short-term funding requirements. For individual investors, it provides the potential for the capital appreciation they need for retirement and the downside protection they desire during periods of market turbulence.

The two key benefits of active low-volatility equity strategies are:

• The potential to tap into a proven alpha source that minimizes risk subject to a return in excess of a benchmark; and
• The potential for a better trade-off between risk and return in an equity portfolio, since these strategies are not required to stay close to the market-cap-weighted index.

Simulations of portfolios of low-volatility stocks seem to exhibit a long-term outperformance relative to high-volatility stock portfolios. Yet, it is still unclear among many investors if the ultimate source of excess returns from low-volatility investing is indeed the risk premium of the targeted factor and/or systematic rebalancing. However, this long-term outperformance is often accompanied by short/intermediate periods of severe underperformance. To avoid such periods of severe underperformance, it is essential to apply an optimization approach.

Optimization focuses on minimizing volatility at the portfolio level by taking into account individual stock volatility as well as correlation between stocks. Because of the potential diversification benefit achieved from lower correlations, an optimized low-volatility portfolio might, in fact, include high-volatility holdings. In addition, optimization allows for an alpha source to be included that is independent of reduced volatility, further increasing the performance consistency and confidence for long-term outperformance. In fact, for a low-volatility portfolio to consistently outperform the market, optimization should ideally incorporate a robust alpha source and an explicit excess-return target in addition to volatility reduction.

The potential for outperformance extends to all reliable implementation of absolute-risk strategies — those strategies seeking exposure to equity markets and their growth potential with lower levels of risk — including low- and managed-volatility equity strategies. Investors often use the terms “low volatility” and “managed volatility” interchangeably. However, we define low-volatility equity strategies as seeking benchmark-like returns with considerably lower total risk; and managed volatility equity strategies as seeking to outperform the benchmark with lower total risk. Therefore, low-volatility equity strategies focus primarily on minimizing risk within equities while managed-volatility equity strategies seek balance between risk reduction and alpha generation — applying more dynamic risk-reduction to equity management in varying volatility regimes.

In real life, markets are constantly changing, and finding the optimal target weights will depend on the balance between risk and return in the portfolio. It then makes sense to respond to the changing market environment by varying the asset weighting decisions in a disciplined fashion in order to allow the absolute-risk strategy to adapt in a more timely fashion to changing market conditions.

Low-volatility investing should be about consistency and confidence. Solely relying on anomalies is not required; on the contrary, sophisticated managers who comprehend the relevant effects can confidently achieve the goal of capturing the equity premium at higher efficiency and lower risk than the market, and help achieve the overall goal to lower plan risk without sacrificing returns. Additionally, the low-volatility investing will tend to receive a boost to its outperformance relative to the market because its returns compound better: Following a market drawdown, the return needed to break even is lower and can be achieved in a shorter time frame. For example, recovering from a 20% drop requires a positive return of “only” 25%, while recovering from a 50% drawdown requires a return of 100%.

So, what path of implementation should an investor follow? Given that low-volatility equity strategies generally focus solely on minimizing risk, they are a potential replacement for a passive large-cap core equity portfolio, which has no requirement for alpha generation. Additionally, given that managed-volatility equity strategies balance risk reduction with alpha generation, they are a natural replacement for passive and active management in areas where alpha expectations are moderate or high.

To conclude, many institutional investors are not now positioned to protect against market volatility and, given that this volatility is likely going to continue or increase, it is necessary for investors to determine how low volatility and managed-volatility equity strategies fit into the overall portfolio structure. Of course, lowering the volatility of asset returns cannot be the sole objective for the majority of investors; long-term expected compound returns must be preserved as well. Low-volatility equity strategies allow investors to capture equity market-like returns with considerably lower total risk. Additionally, when investors still need alpha from active management to close the spread between the expected long-term return on plan assets and the beta return from strategic assets, managed volatility equity strategies can help achieve the goal of higher long-term expected returns with lower total risk.

Richard Yasenchak is client portfolio manager at INTECH in West Palm Beach, Fla.