The Function of Low Volatility Methods in Funding Portfolios 

Low volatility fairness methods attraction to traders for a lot of causes. First, they assist maintain our portfolios invested in equities in periods of market turmoil. Second, when well-constructed, they usually exhibit larger risk-adjusted returns than their larger volatility counterparts.

Whereas basic surveys of low volatility methods present that they do certainly protect traders from market-driven danger, what’s continuously ignored is that these similar methods may be insufficiently diversified or danger managed. To that finish, we’ll look at the vital parts of an efficient low volatility portfolio building course of. These parts allow the development of low volatility portfolios with extra diversification and considerably higher risk-adjusted returns than the usual low volatility technique.

Low Volatility Methods: Three Potential Drawbacks  

Low volatility stocks can deliver a premium over the longer term. And whereas they might present each volatility discount and capital safety in bear markets relative to cap-weighted indices, not all low volatility methods accomplish this to the identical diploma. Certainly, many commercially accessible low volatility methods endure from frequent drawbacks.

1. A Lack of Diversification

Inverse volatility and minimal variance optimization are two frequent methodologies in low volatility methods. In inverse volatility portfolios, a inventory’s portfolio weight is proportional to its danger. Such portfolios penalize excessive volatility shares and reward their low volatility counterparts. They will also be extremely concentrated. The identical criticism applies to the minimal variance optimization approach, which, with out numerous constraints, can even unduly obese the portfolio in a number of shares.

2. Damaging Publicity to Different Rewarded Elements

Worth, Momentum, Excessive Profitability, and Low Funding, specifically, are among the many components which have rewarded traders through the years, however low volatility methods can underweight such components and represent a drag on the long-term danger adjusted efficiency.

3. Extra Threat by Sector and Regional Exposures

Low volatility portfolios could have persistent sector or regional exposures that may open them as much as undo macroeconomic dangers. 

A Higher Approach to Construct Low Volatility Portfolios 

There are several remedies to these diversification- and risk-related challenges in low volatility portfolios. To handle the surplus weighting challenge, we are able to construct extra diversified low volatility portfolios by deciding on weights based mostly on a number of optimization frameworks and introducing strong weight constraints. Each mannequin has parameter estimation dangers as a result of its explicit structure. By averaging throughout a number of fashions, we are able to cut back a lot of the mannequin danger that comes with counting on a single framework. As well as, with no appreciable quantity of at instances advert hoc constraints, corresponding to min-max weights on shares or sectors, a given mannequin could produce overly concentrated or in any other case insufficiently diversified portfolios. To handle this challenge, we use so-called norm weight constraints that avoid concentration better than ad-hoc, sample-dependent constraints. (We additionally make use of principal element evaluation — PCA, a statistical approach — to de-noise the covariance matrices with which we assemble our portfolios.)

One other technique to tackle diversification in a low volatility technique is to extend a portfolio’s issue depth. This measure, when utilized to a single inventory, is solely the sum of particular person issue exposures, or betas, in a portfolio. So, if we’re deciding on shares for a low volatility portfolio, we want these with excessive publicity to the low volatility issue, however we additionally wish to filter out shares with vital detrimental publicity to different rewarded components. By implementing such filtering, our low volatility shares may have, to the utmost diploma attainable, optimistic publicity to Worth, Momentum, and different rewarded components. Consequently, in environments the place the low volatility issue is underperforming, the opposite components might be able to “choose up the slack” and protect the portfolio from a few of the injury that the portfolio may incur with out such filtering.

Each rewarded fairness issue has publicity to macroeconomic components. Which issue hundreds on probably the most macroeconomic danger will rely, after all, on the macroeconomic atmosphere, or regime. Nation- or region-specific drivers clarify a lot of a portfolio’s macro danger, so we are able to mitigate that danger by developing portfolios which can be geographically impartial relative to a cap-weighted benchmark. As a result of macro dangers are additionally usually sector pushed, deciding on low volatility shares inside sectors can mitigate macro danger. Sectors are necessary issues since low volatility methods can obese particular sectors, corresponding to Utilities, which can be delicate to rate of interest and different types of danger.

By way of empirical outcomes, the exhibit under exhibits {that a} low volatility portfolio with issue depth filters delivers a major risk-adjusted return in contrast with each cap-weighted and normal low volatility indexes. This holds for each US and Developed Markets low volatility methods.

Low Volatility Fairness Technique Efficiency and Threat Measures 

US Statistics

Developed Market Statistics 

The method described above leads to considerably larger issue intensities for each US and Developed Market portfolios, as the next charts exhibit.

Issue Depth in Low Volatility Fairness Methods 

US Issue Intensities 

Developed Market Issue Intensities 

This strategy additionally reduces macro exposures throughout geographies because the tables under point out. 

Macro Exposures in Low Volatility Methods 

US Exposures

Developed Market Exposures

Conclusion 

Low volatility fairness portfolios may be worthwhile additions to investor portfolios. They permit asset homeowners to remain invested in equities even amid market turmoil. However, not all low volatility methods are created equal. Many lack the diversification and danger management wanted to protect towards focus and macro danger.

To that finish, the funding course of outlined right here applies numerous measures to make sure the requisite degree of danger management. Of the 2 strategies highlighted, the primary mitigates focus danger by mannequin averaging, and the second applies a filter to weed out low issue depth shares.

By deploying these two strategies, whereas searching for regional and sectoral danger, we are able to increase diversification and cut back dangers within the portfolio by totally different market and macro environments relative to straightforward low volatility benchmarks. 

In case you favored this put up, don’t neglect to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center.

All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Picture credit score: ©Getty Photographs / SimpleImages

Skilled Studying for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can document credit simply utilizing their online PL tracker.