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Does Low-Vol Make Sense?

Written by Charlotte Moore

 –  September 21, 2012

Following the market ups and downs of the last five years, low-volatility indices have become increasingly popular with investors. And despite a recent rally in equity markets, providers of low-volatility indices are benefiting from continuing investor interest.

Volatility is the most widely used measure of equity risk. Proponents of low-volatility equity strategies argue that on a historical basis and in risk-adjusted terms, these strategies will beat the market. But do the arguments stand up?

Dimitris Melas, executive director of MSCI, says: “Over the long term, the performance of a minimum volatility strategy might be either in line with market performance or even deliver a slight outperformance. But the improvement comes in the reduction in risk in the form of lower volatility.”

Imke Hollander, senior investment strategist at BlueSky Group, fiduciary manager to the KLM pension funds, concurs: “Over the economic cycle, they offer at least comparable returns to a market-capitalisation index and, by definition, at least 25% to 30% less volatility.”

The risk-adjusted return of a portfolio is typically calculated via the so-called Sharpe ratio. The Sharpe ratio is calculated by dividing a portfolio’s excess return (over a risk-free rate of interest) by its volatility. “Compare the Sharpe ratio of a minimum volatility index with a market-cap weighted index and the minimum volatility index will have a higher Sharpe ratio or a higher risk-adjusted return,” says Melas.

But while proponents of low-volatility strategies say this approach can provide a better risk-adjusted return that a standard market index, they make it clear that there are no guarantees.

There is no mathematical certainty that a minimum volatility index will outperform. Looking back at historical data there are periods when these strategies have underperformed. Investors need to be able to tolerate relatively long periods of underperformance,” says Melas.

Some strategists also point out that, as a measure, volatility gives only a partial picture of stocks’ risks and is therefore inadequate. One reason for the lower expected returns of high-volatility stocks may be that these stocks can offer positive “skewness” in their returns, says Felix Goltz, head of applied research at EDHEC-Risk.

In a low-volatility portfolio biased towards utilities, consumer staples and healthcare stocks you’re not going to find the next Apple or Google, in other words. The positive skewness of such stocks’ returns means they offer investors the chance to multiply their initial investment ten- or a hundredfold—a return profile that’s very different from that of a typical low-vol portfolio’s constituent stocks.

And the relative performance of low-volatility portfolios will also vary at different points in the market cycle, strategists point out.

Gareth Parker, director of index research, design & development EMEA at Russell Indexes, says: “Generally speaking, low volatility strategies will outperform in bear markets and underperform in bull markets.”

Conventional wisdom dictates that diversification across investment strategies is as important as across asset classes, and therefore a low-volatility strategy should have a long-term home in any portfolio.

Parker says: “Many of the low volatility products are designed to be short-term products but there’s a growing body of data that argues in favour of a long-term position in a portfolio.”

Gus Sauter, managing director and chief investment officer of Vanguard, says: “In the late 1990s, for example, low volatility stocks were significant underperformers. In that environment it would be difficult to attract and retain investors in this type of strategy. But that’s exactly when investors should have assigned funds to low-volatility strategies because once the tech bubble burst, low volatility stocks outperformed the market.”

A low-volatility strategy might also enable an investor to diversify the growth asset portfolio. Sauter says: “This might allow investors to put more money in equities because it keeps a lid on the risk budget.”



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