(August 30, 2012) — There are ways to achieve better risk-adjusted returns than what the market offers, and low-volatility investing is the answer, according to Aye Soe, director of global research at S&P Dow Jones Indices.
In April 2011, S&P released its low-volatility index, as have its competitors, such as MSCI and Russell.
“Low-volatility investing has been around for 40 years and finally caught on in the last three to four years largely as a result of the 2008 financial crisis,” Soe said.
The paper — titled “The Low Volatility Effect: A Comprehensive Look” — asserts: “Using the Sharpe ratio to measure the effectiveness of each strategy on a risk-return tradeoff basis, our analysis shows low-volatility strategies possess superior risk-adjusted performance over a benchmark portfolio. This desirable risk-return characteristic could have a profound portfolio management implication because the portfolio with a higher Sharpe ratio provides better diversification.”
The paper continues: “It is nearly impossible to analyze the low-volatility effect without discussing the role of traditional equilibrium asset pricing theory. Hence, in addition to providing above-mentioned risk management capabilities, low volatility effect has reignited the debate on what constitutes a market portfolio or an optimal Sharpe portfolio, a tangency portfolio for which there is no other portfolio with the same or higher expected return with lower volatility.”
In April, Pim van Vliet, PhD, a portfolio manager at Robeco, told aiCIO that the lure of low-volatility stocks is their long-term performance. “The Netherlands was the first nation in Europe to really embrace the approach before the crisis, then over the last two years we have seen pension schemes large and small allocate to the strategy,” said van Vliet.
According to critics of low-volatility strategies, however, while a strictly low-volatility investing sounds like a strong idea, it is often an unrealistic way to achieve assumed returns. It is not possible to successfully meet return assumptions by moving down the efficient frontier. Instead, institutions must keep an eye on and guard against left-tail exposure while seeking a high enough risk strategy to surpass assumed return expectations. Pursuers of low-volatility strategies thus must be aware of its shortcomings, critics point out.