Of course, the traditional backtesting caveats apply to these results, especially in the case of low volatility strategies spanning a decade dominated by the bookend bear markets of the Tech Bubble and Global Financial Crisis. On the opposite side of the ledger, the excess returns for the low-volatility strategies are very similar to other non-price-weighted indices over the same time periods. If such disparate weighting methods as the Fundamental Index methodology and equal weighting produce similar excess returns, then an excess return from weighting by the inverse of volatility should have a similar expected result. Shocking to the casual observer, high-vol and low-vol both beat the market, by comparable margins, as long as the portfolio weights are indifferent to price!
Of course, we are comparing paper portfolios that do not reflect the real friction of transaction costs and market impact. In the real world, these costs are significant and investors should take steps to minimize them. Therefore, an efficient low-volatility equity portfolio ought to:
- maximize liquidity,
- minimize turnover, and
- maintain some semblance of economic representation.
In addition to these portfolio attributes, the construction methodology should be easy to understand and replicate, given the proclivity of passive investors for simple and transparent solutions. Our research has indicated that the current low-volatility indices all fall short on one or more of these goals, so they arguably cannot be used as core strategies.
Putting it Together
A 25% reduction in equity volatility is meaningful. If we can save that much with our dominant total portfolio risk contributor, we should have the risk budget to include higher-risk real return asset classes, right? The answer is “yes,” as we show in the third column of Table 2 (Third Pillar with Low Vol). Here, we replace half of each equity exposure with a comparable low-volatility exposure. Consistent with our empirical findings, we assumed each low-volatility equity strategy would outperform its cap-weighted counterpart by 1% per annum.9 We also assumed the low-volatility strategies would produce volatility levels 25% below that of the cap-weighted portfolios.
Overall, for the Third Pillar with Low Vol option, portfolio volatility declines to a similar level as the Typical U.S. Plan while expected return increases by 80 basis points to 6% per annum. To be sure, this return estimate still falls short of, and in some cases well short of, investors’ targeted returns, which are typically in the 7–8% range.10
Naturally, as with any “new” idea, there will be early critics aplenty. “It’s just a backtest… past is not prologue” or “it’s just a clever repackaging of Fama–French.” But this is not a “new” idea; Low Volatility was touted by Bob Haugen11 20 years ago. And “past is not prologue” has been used to dismiss ideas throughout history—some prematurely.
Regardless of the criticisms, low-volatility equities have important asset allocation implications for investors, especially when the traditional anchor to windward for most U.S. investors—U.S. Treasuries—sport dangerously low yields and rising credit concerns. We think it merits serious consideration.
While my personal experience of hurricanes is fortunately minimal, one nearly postponed my own 2006 nuptials in Baja, California. While we spent a few days fretting, the storm passed with minimal damage a day before the guests began to arrive. Not long after, like many new husbands, it didn’t take long for me to realize that life, as I knew it, had changed. Rest assured, the changes are for the better, but married life was still an adjustment for me—the big screen TV still called on Saturdays! But the miracle of TiVo and the digital video recorder eased the transition.
Today’s investors similarly are confronted with a future that will be different from everything they’ve grown accustomed to over the past 20 or 30 years. As they look to change priorities with relatively constrained risk budgets, we assert that low-volatility equities, like my DVR, can help ease the transition. By no means can they miraculously solve all of investors’ dilemmas, but they can be a simple and low cost tool to effectively broaden diversification and risk posture in the decades ahead. We look forward to sharing more of our research into this investment approach in the coming months.