“The fox knows many things, but the hedgehog knows one big thing” – Isaiah Berlin
The Fund Management industry has recently seen an explosion in demand for mandates and benchmarks that seek to produce equity portfolios with reduced volatility. We find that these mandates typically take one of two approaches:
1. “Vol Control
” approach: Volatility Control at an aggregate level through a de-gearing mechanism which depends on the level of volatility of the reference equity index
2. “Low Vol Stocks
” approach: Selection of low volatility equities and/or weighting individual stocks according to inverse of their individual volatility
The industry so far appears to have favoured the second approach: on 3 December 2012 iShares announced the launch of a “low volatility” range of ETFs traded on the London Stock Exchange to add to the offerings by Janus, Natixis (Ossiam), Rabobank, Jupiter, Acadian, AXA Rosenberg, Invesco, SEI, State Street and others. S&P, FTSE, MSCI and RAFI all offer indices tracking these kinds of portfolios.
But what are the differences between the two approaches, and which is better for pension schemes’ needs? And, based on the data currently available, has either approach achieved its objectives?
We make a comparison using the most widely available information on one particular implementation of each approach.
We show that, while both approaches appear to have achieved their objectives over the last ten years, the preference for Low Vol Stocks over Vol Control is likely driven more by recent short term returns than by long term risk-adjusted returns; on this basis the Vol Control approach would be preferred.
Our conclusions regarding the risk-adjusted return advantages of a volatility control strategy are in agreement with a recent paper
by Guido Giese, which concludes that “over the long term investors can clearly improve their long-run Sharpe ratio by shifting their investment to a corresponding target volatility index.”
We also show that the Low Vol Stocks
methodology can result in high concentrations to individual sectors, which can be a major driver of returns.
To read the full paper, click here
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]