(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!”
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.