Taking the Long View on Low Vol | Chief Investment Officer

Before committing to a low-volatility strategy, a leading strategist advises, investors must first commit to ditching short-term evaluations and relative risk benchmarking.

(September 11, 2012) – While most chief investment officers dislike much attention being paid to their funds’ quarterly and one-year returns—institutional investing is a long game, after all—some judge their outsourced managers on those very timelines.

But any CIO considering a low-volatility strategy had best apply their long-range perspective to external managers as well, according to equity strategist Ryan Larson, who recently published a guide to low-vol with Research Affiliates.

“Because of high tracking error,” Larson writes, “successful low volatility investing must throw out any comparison to relative risk measures such as the information ratio”—the ratio between excess return and tracking error.

Take the last couple of years, for example. A low-vol portfolio’s performance, measured via information ratios and other relative risk benchmarks, would have bordered on bipolar: During 2011 low-volatility stocks outperformed the broad stock market by 10%, then in the first quarter of 2012 they lagged by 5%, and outperformed again in the following quarter by 5%. As Larson writes, “What a seesaw!”

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And external managers’ fates are often tied to the information ratio: “Three years is typically the longest boards allow a manager to underperform the market before pulling the plug. Portfolio managers are a self-preservation-oriented bunch, so they began to manage their portfolios with an eye on the index and toward minimizing relative risk (tracking error), with less concern for absolute risk (standard deviation).”

Low-volatility strategies can offer substantial rewards: by Larson’s calculations, they earn a near one-to-one ratio of return to risk, whereas cap-weighted S&P 500 investors shoulder twice the risk for the same return.

Making—or perhaps allowing—these strategies work is all a matter of perspective: “It is very difficult for a single portfolio approach to be both a relative risk and an absolute risk winner. The more one wants to shift from a relative approach to an absolute one, the more one will have to screen out large portions of the market and, accordingly, accept more tracking error.” In return, the low-vol investor should get, well, returns.

Read Larson’s full paper here.

(September 5, 2012) — The California Legislature successfully passed a bill to overhaul the state’s public pension system on Friday, the final day of the 2012 legislative session.

The Assembly voted 48 to 8 in favor of the legislation, and the Senate passed it 38 to 1. In an all-too-rare display of political efficiency, California Governor Jerry Brown had introduced the reform package (bill AB340) just three days prior to its approval. He is expected to sign it into law shortly.

The legislation, which takes effect in January, stipulates that new public employees must pay for at least half of their pensions, and grants local governments the power to raise employee contributions. Under the reformed rules, the retirement age for new state, county and municipal workers rises from 55 to 67 for general employees, and 50 to 57 for police and firefighters.

The nation’s largest public pension, the California Public Employees’ Retirement System (CalPERS), has come out in support of the newly passed reform package’s goals. “The long, arduous and often contentious journey of public pension reform has reached a major milestone,” wrote CalPERS’ President Rob Feckner and CEO Anne Stausboll in a statement. “The legislative leaders and stakeholders involved in the pension reform process have done extraordinary work. They have produced a set of reforms that moves us forward to having a stronger and more affordable system. While the reforms may not satisfy those on each extreme of the spectrum, they are a positive and significant step in ensuring that public pensions are sustainable, secure and cost-effective.”

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Feckner and Stausboll estimate the reforms will save California taxpayers between $42 billion and $55 billion over 30 years for CalPERS plans alone. For the state’s teachers’ retirement system, the new legislation will reduce required contributions by roughly $23 billion by 2032. In their statement, the two heads of CalPERS’ call these “real and significant savings.”