How to Build Better Low Volatility Equity Strategies  

The Function of Low Volatility Methods in Funding Portfolios 

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

Whereas normal surveys of low volatility methods present that they do certainly defend buyers from market-driven threat, what’s incessantly ignored is that these similar methods could be insufficiently diversified or threat managed. To that finish, we are going to look at the vital elements 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 obtainable low volatility methods endure from widespread drawbacks.

1. A Lack of Diversification

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

2. Unfavorable Publicity to Different Rewarded Components

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

3. Extra Danger via 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 Solution 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 concern, we are able to construct extra diversified low volatility portfolios by choosing weights based mostly on a number of optimization frameworks and introducing strong weight constraints. Each mannequin has parameter estimation dangers because of its explicit structure. By averaging throughout a number of fashions, we are able to cut back a lot of the mannequin threat that comes with counting on a single framework. As well as, with no appreciable quantity of at occasions 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 concern, we use so-called norm weight constraints that avoid concentration better than ad-hoc, sample-dependent constraints. (We additionally make use of principal part evaluation — PCA, a statistical method — to de-noise the covariance matrices with which we assemble our portfolios.)

One other option to deal with 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 choosing shares for a low volatility portfolio, we want these with excessive publicity to the low volatility issue, however we additionally need to filter out shares with important adverse publicity to different rewarded components. By implementing such filtering, our low volatility shares can have, to the utmost diploma doable, optimistic publicity to Worth, Momentum, and different rewarded components. In consequence, in environments the place the low volatility issue is underperforming, the opposite components might be able to “choose up the slack” and defend the portfolio from among the harm that the portfolio would possibly incur with out such filtering.

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

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

Low Volatility Fairness Technique Efficiency and Danger Measures 

US Statistics

Developed Market Statistics 

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

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 beneath point out. 

Macro Exposures in Low Volatility Methods 

US Exposures

Developed Market Exposures

Conclusion 

Low volatility fairness portfolios could 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 threat management wanted to protect towards focus and macro threat.

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

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

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

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