Take a look at your stock allocation. A good dose of low volatility equity might surprise you.
by Matt Peron, Managing Director of Global Equity, and Ben Goetsch, CFA, Equity Strategist
Low volatility equity strategies have defied traditional assumptions about how risk and return pair up, based on our historical research. This is what makes low volatility such a valuable factor. Most discussions of low volatility strategies have tended to focus on the potential to outperform cap-weighted benchmarks by overweighting low volatility stocks. While this is clearly interesting and merits attention, it ignores perhaps the most important feature of a low volatility strategy — the ability to potentially improve the risk-return profile of a portfolio.
A Wide Range of Risk
Historical patterns clearly indicate that volatility is far from uniform across equities. In Exhibit 1, we divided developed-market equities into five portfolios (quintiles from lowest volatility to highest) based on historical volatility. The resulting portfolios demonstrate a range of volatility, indicating that stocks identified as low volatility tend to be significantly less volatile in the future than stocks identified as high volatility.
Performance: Low Volatility Stacks Up Well Historically
If traditional financial theory holds true, we should assume that portfolios with significantly different levels of risk should also demonstrate significantly different levels of return. Specifically, higher volatility portfolios should be rewarded with higher levels of return, and lower volatility portfolios should demonstrate commensurately lower returns. Exhibit 2 clearly indicates that has not been the case.
Using only the highest quintile and lowest quintile for clarity, we calculated the excess returns relative to the broader market. Not only do the lowest volatility stocks tend to keep up with the broader market, but they actually outperform higher volatility stocks over nearly every 5-year period we examined.
Put Low Volatility to Use: Fine-Tuning the Risk and Reward
This finding can have broad implications, particularly in an environment where return expectations across asset classes are at historically low levels. Our research and experience suggest that low volatility strategies that are reasonably well diversified can deliver 20% to 30% less volatility versus the broader market. Even if a low volatility portfolio could simply match the performance of the broader market, investors can expand their equity allocations and increase return potential without increasing portfolio volatility.
To illustrate, in Exhibit 3, we use a sample portfolio allocated 60% to equities and 40% to bonds. We can replace the equity allocation with a low volatility strategy that performs in line with the cap-weighted benchmark with 20% less volatility, on the low end of the expected volatility reduction. If we increase the low volatility equity allocation to 75%, we can achieve improved historical return with less volatility. Further, more equity can mean more return potential going forward.
For investors grappling with the potential for low returns in the intermediate-term, low volatility strategies provide an interesting tool to potentially improve performance within their existing risk budgets. Not only do these strategies present the opportunity for outperformance within equity allocations, but their lower risk profile allows for potential shifts in asset allocation to boost returns without increasing overall portfolio volatility. Further, while we expect low volatility strategies to deliver a premium relative to the market over time, as these strategies have done historically, investors can still benefit from the improved risk/return tradeoff.
Learn More
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Global Low Volatility: Benefiting From an Actively Designed Approach
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