Paper Voices Caution Over Low-Volatility Strategies

(November 30, 2011) — Minimum variance strategies have become increasingly popular given the high levels of market volatility experienced by equity investors during the 2008–2009 financial crisis, a report by Ronnie Shah of Dimensional Fund Advisors asserts. 

However, the report concludes that investors who aim to reduce portfolio volatility can usually achieve a reduction through investments in fixed-income rather than sacrificing expected returns by investing in a low-volatility strategy.

“Minimum Variance strategies attempt to construct equity portfolios that minimize volatility,” according to the report. “These low volatility strategies make no explicit assumptions regarding expected returns. Volatility is estimated using historical stock return volatility and correlations between individual stock returns and market movements. If these ex ante estimates of volatility are stable over time, the minimum variance story predicts this portfolio will have substantially lower volatility than the market portfolio.”

The article outlines and expands on the following points:

1) Low-volatility strategies such as minimum variance have similar returns with substantially less volatility when compared with a related market portfolio over the period 1968–2010. 

2) The analysis shows that low-volatility strategies’ gain in performance can largely be attributed to industry bets and value tilts. 

3) The weighting schema used to construct minimum variance portfolios contributes little to the performance of these strategies. 

4) Similar Sharpe ratios can be attained using a balanced portfolio of stocks and bonds.

The study concludes that simulations of low-volatility strategies (such as minimum variance) yield levels of average returns similar to those of equity market indices. 

The report by Shah comes after many consultants noted earlier this month that as volatility-focused strategies gain prominence, they are also skeptical of “marketing gimmicks.” “Investors are desperate for a model that is responsive in different market environments – controlling downside risk while not sacrificing upside potential,” Michael Dunn, chief research officer of Boston-based TruColor Capital Management, told aiCIO. “There’s a herd mentality in extreme downside markets, and managed-volatility strategies aim to limit exposure during such periods especially,” he said.

Consultants, however, voice caution over the host of low-volatility strategies that have come to market. “These strategies may be marketing-driven in response to the current turbulent market environment,” NEPC’s Erik Knutzen told aiCIO earlier this month. “There are certain timeless approaches that make sense,” he said, referring to risk parity, which has attracted attention as of late — a strategy that NEPC has championed. “Some of these new low volatility strategies may leverage previous ideas – but take advantage of what appears to have worked in the most recent environment…We argue that you shouldn’t build a portfolio based on only one return anomaly, since those anomalies can be arbitraged away,” he continued, adding that NEPC agrees that investors should be dynamic in their allocation based on risk and return.