With some of the deepest equity drawdowns we’ve seen in years, investors are taking a serious look at low volatility equity strategies. After all, the diversification potential low vol provides to equity allocations extends meaningfully to the broader portfolio. Analyzing that potential, however, isn’t conventional.
We recommend using a consultant to evaluate institutional investment strategies, but that’s particularly true for assessing low volatility equity strategies given their variations in design and construction. Assembling a “clean” peer group of low volatility equity strategies to use for comparison purposes requires the expertise and experience consultants can provide.
Performance for low volatility strategies might look great in 2022, but these strategies are designed to deliver superior risk-adjusted returns over the long-term; therefore, performance results that include a full market cycle are essential for setting expectations across all market environments. Reducing these statistics to a single annualized figure for the entire period may work as a shorthand to summarize outcomes, but for many, rolling periods (e.g., one, three, or even five years) can help illuminate variations over time within those different environments.
Below is a list of performance measurements for assessing effectiveness and expectations for low volatility equity strategies. Here, we provide the measurements you might anticipate looking for on a standard factsheet, along with a few intriguing, less common metrics.
| METRIC | COMMON | LESS COMMON |
| Volatility | Historical (ex-post) Standard Deviation of Portfolio Returns Frequently used to describe the strategy’s reduction in risk relative to a cap-weighted index. |
Estimated, (ex-ante) Holdings-Based Volatility Allows you to examine a strategy’s position relative to the market at a specific point in time. |
| Beta |
Historical (ex-post) Beta |
Predicted (ex-ante) Beta Like estimated risk, designed to measure a strategy’s sensitivity to market moves at a particular moment. |
| Downside Risk | Maximum Drawdown A singular measurement of downside protection compared to the worst of the market. |
Downside Deviation Standard deviation of negative relative returns. Isolates downside or “bad” risk from the upside volatility that can drive returns. |
| Return | Annualized Return and Upside and Downside Capture Establishes expectations for alpha, as well as asymmetry of returns in various risk regimes. |
Mean and Difference Of Upside and Downside Capture Across Risk Regimes The mean indicates a strategy’s defensiveness over a full market cycle, while the difference reflects how well a strategy maximizes the asymmetry of returns. |
| Efficiency | Sharpe Ratio A strategy’s return less the risk-free rate, divided by standard deviation. A Sharpe ratio higher than the benchmark should be a minimum requirement for any defensive equity strategy worth considering. |
Sortino Ratio A strategy’s return less the risk-free rate or minimum acceptable return, divided by downside deviation. Similar to Sharpe ratio, but penalizes for downside volatility. |
Using a low volatility index as a benchmark for defensive equity strategies seems like it would make sense, but it’s less than straightforward under closer scrutiny. Major equity benchmark providers S&P Dow Jones, FTSE Russell, and MSCI all maintain rules-based low volatility equity portfolios they call indexes – but they shouldn’t be confused with their cap-weighted counterparts by any stretch of the imagination.
For one thing, which index approach is valid? It’s arbitrary to endorse one index over another given the wide range of construction methodologies. These so-called indexes are actually active strategies – they all have distinct stock selection processes, often have wide return dispersion, and some even lack transparency.
Even a cursory glance makes it quite obvious that unlike cap-weighted indexes, which generally feature similar construction methodologies, there’s a clear divergence in approaches here.
| Index | Construction Methodology | Example* Parent Index | Constraints | Rebalancing Frequency |
| S&P Low Volatility | Select least volatile stocks using trailing 12-month daily returns, weight in inverse proportion to volatility (least volatile = largest weights) | S&P 500 | Specific number of constituents (e.g., 100 stocks for S&P 500 Low Volatility) | Quarterly |
| FTSE Minimum Volatility | Optimize weights for lowest absolute volatility using a covariance matrix based on trailing two-year daily returns | FTSE All-World | Individual stock, industry, and country | Semi-annually |
| MSCI Minimum Volatility | Optimize weights for lowest absolute volatility using a covariance matrix based on proprietary Barra risk estimates | MSCI World | Minimum and maximum constituents, individual stock, sector and/or country, common equity factors | Semi-annually |
*Represents an example of a regional cap-weighted index from the same provider that the defensive equity index uses as its investment universe.
Instead, many low volatility equity investors simply use cap-weighted benchmarks and Sharpe ratio or Jensen’s (beta-adjusted) alpha to evaluate performance. Investors prefer Sharpe ratio if total volatility – both systemic and idiosyncratic risks – is most relevant. If only systemic risk is relevant, then Jensen’s alpha may be more appropriate. This practical approach recognizes that defensive equity investing isn’t about beating a defensive equity index; rather, it seeks a superior risk-return profile to cap-weighted benchmarks.
Establishing realistic expectations for low volatility strategies is vital. Because markets have more up than down days, losing sight of the value these strategies seek to provide is easy. Having the conviction and discipline to hold low volatility strategies as important diversifiers through bull markets is hard. The fear of missing out, or FOMO, is real.
Painting an accurate picture of low volatility performance is challenging, however. Despite the substantial growth in low volatility assets over the last 10 years, live track records available for low volatility equity strategies are relatively short, and precious few include anything resembling an entire market cycle. Consequently, we attempt to provide a representation of low volatility performance using MSCI World Minimum Volatility Index with the following caveat: these returns are back-tested by MSCI since they begin on May 31, 1988, yet MSCI didn’t create this index until nearly 20 years later on April 14, 2008.1
Intech has been managing low vol portfolios for over a decade now. We offer a wealth of resources on the subject, including how to differentiate between low volatility equity strategies and their role in portfolio construction. Our recent paper, “Low Volatility Investing: Assess, Analyze, and Act” is a terrific primer on these topics.
1. The MSCI World Minimum Volatility (USD) Index was launched on April 14, 2008. Data prior to the launch date is back-tested test (i.e. calculations of how the index might have performed over that time period had the index existed). There are frequently material differences between back-tested performance and actual results. Past performance -- whether actual or back-tested -- is no indication or guarantee of future performance.
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Past performance does not predict future returns. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment.
Low volatility strategies are likely to underperform the index during periods of strong up markets and may not achieve the desired level of protection in down markets. Indices are not available for direct investment; therefore, performance does not reflect the expenses associated with the active management of an actual portfolio.
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