Sentiment surrounding low-volatility investing ranges from Zen to fear, aiCIO's first survey on the topic shows.
There is something mildly thrilling in an inaugural survey. aiCIO has a robust and growing cadre of engaged readers willing to spend their limited time filling out questionnaires, yet until the results emerge, we really have no sense of where our readership will go. The Risk Parity Edition of our Surveys of Asset and Geographical Allocation (SAGA) Series showed the strategy to be more prominent than was previously believed; our Investment Outsourcing Edition indicated that there was little agreement on what actually constituted "outsourcing." With this survey—our first to touch on low-volatility investing—a vast array of opinions emerges, and beyond the concerns regarding the strategy, the only consensus is this: There is no consensus at all.
Limited Knowledge, Little Agreement
First things first: We all need to learn more about low-volatility investing. There is strong evidence that the low-volatility anomaly, despite being the antithesis of an efficient market, has persisted for decades—at least if one ignores the possibility that the outperformance is due to hidden illiquidity in these portfolios. There are reasons to believe that they will continue to persist. (To find out two potential reasons why from a really smart guy, figure out how to use that weird looking barcode below.) Yet according to this survey, only 38% of a very intelligent set of asset owners have a "strong" or "very strong" knowledge of this potentially lucrative asset class.
Perhaps even more striking is that 45% of the 184 pensions, endowments and foundations, sovereign funds, and other asset owners currently (or plan to) allocate assets to low- or minimized-volatility strategies—which by definition implies that there is a not insignificant number of respondents who are investing in a strategy that they do not fully understand. This disturbing trend, surprisingly, is most apparent within the silo of asset owners in which most observers would least expect it: the endowment and foundation (E&F) silo. The respective figures: public plans (42% with "strong/very strong" knowledge, 41% who allocate or plan to), corporate plans (44%, 44%), and endowments and foundations (35%, 49%). Odd.
Part of this lack of understanding perhaps stems from the various ways in which low-volatility investing is executed by managers. The most commonly cited execution definition—"managed volatility, where a volatility level is targeted"—is chosen by only 25% of this subset; the more technical execution that describes a more rigid low-volatility method—"As defined by Markowitz’s Portfolio Theory (volatility replaces risk)"—is chosen by just 8%. Shockingly, 10% of those who use or plan to use these strategies don’t even know what execution strategy their manager most often employs.
The one purely open-ended question asked within this survey revolves around benchmarking. Perhaps the most nebulous area of low-volatility is how to measure its success or failure, and thus we asked respondents how they benchmark, or plan to. Unsurprisingly, like with the majority of the survey, a vast array of answers is given. Some respondents name a specific index, although there was seemingly little consensus on this, with answers including "Russell 3000," "Russell 1000," "S&P 500," "MSCI ACWI & MSCI Low Vol," and "T-Bill +5%," to name a few. More originally, some respondents note the basic problem with the question—that there is no standard low-volatility benchmark. "We use low-volatility equities as part of a portfolio with various styles," one respondent notes, continuing: "We use a cap-weighted benchmark for the entire portfolio and accept that the low-volatility portfolio has a high tracking error." Perhaps the most expressive, and insightful, answer: "Great question! I think the answer is, we won’t. Benchmarking it to [a] cap-weighted index will lead to tracking error beyond stakeholder comfort."
Uses, and Why Not To
As noted, perhaps the only area of true consensus within this survey can be found in respondents’ concerns over the strategy—but even this is a loose consensus indeed. Both those who use/plan to use and those who don’t use low-volatility strategies were asked what concerns them most. While both groups chose a different first concern—"tends to underperform rising markets" for users/planners and "may not consistently provide alpha" for non-users—the percentage choosing these answers (50% and 32%, respectively) at least offers a modicum of agreement. Further down the rankings, however, answers once again diverge: While users/planners rank the difficulty of benchmarking third with 19%, non-users rank it sixth with 12%; the rankings of "does not align with investment objectives" diverges wildly as well, but this may be a result of a selection bias of sorts (those who use it clearly think it aligns with their investment strategy).
Responses from 184 asset owners were accepted for the survey over a period of three weeks, ending March 30, 2012. aiCIO would like to extend a special thank you to all those that submitted responses for the survey, as well as those vendors, asset owners, and consultants who helped the aiCIO editorial and survey teams construct the survey. For more information, contact Quinn Keeler, 203.595.3270.