Low-Volatility Equity Strategies: A Common-Sense Perspective?

(April 24, 2012) — As volatility continues to hurt investors, proponents of low-volatility strategies claim the approach is a common sense reaction to a turbulent market environment. 

Adrian Banner, Ph.D., Chief Investment Officer at INTECH Investment Management, expresses opposition to critics of low-volatility strategies, many of whom say that for a plan sponsor, moving down the efficient frontier is not possible in this market environment — one that is dominated by an attraction toward low-risk strategies.

“My opinion is that the market index is not even on the efficient frontier — it’s substantially below it. The capital asset pricing model (CAPM), which concludes that the market portfolio lies on the efficient frontier, is based on the crucial assumption that everyone should have the same return and risk expectations. Since that’s not true, there’s no reason to assume that a cap-weighted index should be on the efficient frontier. In fact, there has been mounting empirical and theoretical evidence that the converse is the case,” Banner says.

Low-volatility equity strategies, in other words, redirect the efficiency game, proponents of low-volatility strategies conclude. Instead of trying to beat the index, it’s a strategy that aims to have the same long-term returns as the index but with reduced fluctuations.

The reason why low-volatility strategies may seem like a fantasy, Banner says, is because investors think they need to sacrifice something to lower volatility. “But since the fundamental premise of active management is that the index is inefficient and can be beaten in terms of returns, investors ought to be able to apply the same sort of skills by targeting a reduction of risk while not sacrificing long-term returns,” he says.

In response to NEPC’s Erik Knutzen, who asserted that low-volatility stocks may be relatively overvalued in the current environment, Banner said:

“A well-constructed low-volatility equity portfolio doesn’t just have low-volatility stocks. A collection of high volatility stocks that is not correlated may exhibit lower volatility when combined than a collection of low volatility and correlated stocks.” In other words, it’s all a question of diversification.

What Banner and other proponents of low-volatility equity strategies agree on is that these sort of strategies are strong not only because they have outperformed the market over the long-term, but because there are inherently fewer fluctuations. “It means that in principle, you typically get to your return objectives in a shorter amount of time,” Banner says.

Related article: Year in Preview, Low-Volatility Investing