(March 7, 2012) — There has been increasing interest among institutional investors in the application of risk-based investment strategies in their equity allocation since the last financial crisis, according to a recent whitepaper by MSCI.
The paper concludes: “While the key motivation is often the need to cushion and diversify extreme risk, the possibility of capturing the ‘low volatility effect’ provides an additional incentive for the adoption of risk-based investment strategies. In this note, we examine the historical behavior of two risk-based investment strategies and investigate their potential application in an institutional equity portfolio.”
The paper — written by Chin Ping Chia, Dimitris Melas and Tom Zhou — asserts that while risk-based strategies tend to outperform when equity markets are declining, it is important to point out that they tend to lag behind when the markets experience upticks. Furthermore, the paper notes that risk-based strategies aim to provide alternative beta exposure for institutional investors through an objective and transparent index construction process.
MSCI concludes that despite risk-based strategies underperforming during periods of market upticks, lower volatility combined with comparable average monthly performance has in many instances led to higher long-term compounded returns, measured against a more volatile return series. “Therefore the application of risk-based strategies for capturing the low volatility effect may be viewed as more appropriate for a long-term investment strategy than for short-term risk reduction,” according to the firm.
Risk-based approaches to portfolio construction have gained traction among investors eager for more stability in a volatile environment. This was exemplified in November 2010 by a decision by the California State Teachers’ Retirement System (CalSTRS), one of the largest US public pensions, to explore a risk-based allocation approach that would divide assets into risk buckets, instead of traditional asset classes.
“The purpose of this Investment Committee project is to look at the portfolio through a different lens, to help quantify and manage risk in a different way,” said a memo to the board written by CalSTRS chief investment officer Chris Ailman. “While this may seem like a simple exercise, it turns the foundation structure of the investment portfolio on its head. We define our world by asset classes; this structure ignores the traditional definition….This new idea for asset allocation is almost radical in today’s setting.”