Low volatility investment strategies have gained increasing interest in recent years as investors have faced the challenge of managing risk in a highlyvolatile market environment.
For investors looking to reduce the volatility of their returns while maintaining their equity exposure, reshaping their equity portfolios through ‘smart beta’ approaches, such as low volatility strategies, is one way to pursue this objective.
First, it is important to stress that low volatility strategies have a place,but are not a “silver bullet” and should therefore be part of a broader multi-asset diversification strategy.
Additionally, investors should always maintain a flexible posture, updating their portfolios when smart beta opportunities evolve, or even disappear.
Low volatility equity strategies may offer the prospect of continued exposure to equity returns with lower volatility of returns than the equity market at large. For example, the Russell Defensive Global Equity Index, which consists of lower volatility, higher quality stocks, has a standard deviation of returns for the time period 1996 to 2012 of around 13.5%with an annualised return of 7.4%.This compares to a standard deviation of 16.6% and an annualised return of 6.0% for its parent index, the Russell Global Developed Equity Index, for the same time period.
The key point is that one does not always need a fixed income allocation to help reduce portfolio volatility. Sometimes, a low volatility equity strategy can help accomplish this goal without diversifying away from equities.
You would expect that lower volatility equities would generate lower returns,but studies have shown that historically this segment of the market has generated similar or better returns to the broad equity market over time in many circumstances.
This “low-volatility anomaly” has been well documented yet many portfolios continue to be dominated by riskier, highervolatility stocks.
For example, one theory identifies an irrational preference for risk – the general public enjoy entering lotteries and have a tendency to be overconfident - as a potential cause. A second theory points to investors setting market-relative return objectives for their managers rather than absolute return objectives. Low volatility equities have lower absolute volatility, but when volatility is measured relative to the market at large, they appear among the riskier stocks and so are less favoured by managers working to a marketrelative objective.
Despite the fact that this anomaly has now been widely identified, a lot of money continues to flow into the low volatility sector,bidding prices up. We estimate that assets under management in dedicated low volatility products have doubled globally over the last two years, to around $100 billion* from May 2011. (*estimate)
This growing awareness of low volatility strategies and growing assets into this sector may ultimately arbitrage away much of the low volatility opportunity. Yet it doesn’t take away from the original potential value of gaining exposure to those stocks at the more stable end of the market:well-managed companies with low exposure to debt, consistent earnings, and lower volatility. Most investors looking for ways to generate an equity-like return with lower volatility will find these characteristics desirable as a part of their long-term strategic allocation.
While low volatility equity does offer some dampening of risk in the equity portfolio, it is still equity. There is a strong correlation of low volatility equity to the broad equity market. For more meaningful risk reduction through diversification,multiasset investors should also look beyond equities to wider opportunities across credit, real assets and skill-based strategies.
Sorca Kelly-Scholte, managing director at Russell Investments Ltd.
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