Low Beta Portfolios: What Could Possibly Go Wrong?

October 17, 2014 (PLANSPONSOR.com) - There is now substantial research to document the existence of the so-called low volatility anomaly.
By PS

Decades of U.S. equity data demonstrate that on a risk-adjusted basis, the lowest volatility segment of the market has outperformed the highest volatility segment by a substantial and consistent margin. Studies of non-U.S. markets have also shown a similar pattern of relative performance in low volatility stocks.

This insight has led to an explosion of investment approaches that aim to exploit this phenomenon. The premise is attractive: capture the equity premium and compound it more quickly by achieving the market return at lower-than-market risk. With such an approach, what could possibly go wrong?

Acadian’s research and management experience has demonstrated that there are, in fact, a number of potential pitfalls en route to the optimal low volatility portfolio. Here are four questions we believe defined benefit plan sponsors should ask when considering a low beta approach.

How is my portfolio constructed? A well-constructed low volatility portfolio is not simply a group of low volatility stocks. Volatility and drawdown need to be addressed at the portfolio level, not merely at the stock level. It is important to understand how each stock relates to others in a portfolio, and simplistic sorting methodologies often have the effect of disregarding this.

How expensive is my portfolio? Defined benefit plan sponsors should be aware that it is possible to create low volatility portfolios across the full spectrum of valuations. Thus, a careful manager can deliver a low volatility portfolio that avoids overly expensive stocks. Many low beta managers do not seem to see the importance of developing this capability.

What is my exposure to interest rate and currency risk (and other hidden risks)? Piling into low beta stocks without attention to portfolio diversification can lead to unintended risk exposures. A naïvely constructed low volatility portfolio can have inadvertent and unrewarded interest rate and currency exposures. Is your manager paying attention to these?

How restricted is my portfolio? Passive, index-linked low beta strategies offer appeal in the form of simplicity. However, an active process is typically a more effective means of capturing the low volatility phenomenon. Such portfolios can be optimized without reference to any benchmark, and thus can draw on the full universe of available stocks. Passive approaches, in contrast, are typically limited to benchmark holdings. An active approach may improve on the fundamental characteristics of passive indices, avoiding expensive stocks. In addition, they can be optimized in local currency terms, to incorporate currency risk into the portfolio construction process. Active low beta implementations also trade more frequently, allowing portfolio risk to be managed continuously and not be limited to rigid (and well-publicized) index rebalancing dates.

 

From the above it should be clear that Acadian believes defined benefit plan sponsors should consider the potential benefits of actively managed approaches when evaluating a low volatility allocation. At the very least, asking your manager these questions will give you greater—and possibly surprising—insight into your low volatility equity investment.

 

Ryan Taliaferro, Portfolio Manager, Acadian Asset Management LLC   

This document was prepared by Acadian Asset Management LLC.   The views expressed within are those of Acadian and are subject to change with market conditions. This is provided for informational purposes only and should not be construed as investment advice, or an offer to sell or a solicitation of an offer to buy any security or obtain business.  

This document has not been updated since it was published and may not reflect the current views of the author(s) or recent market activity. Market conditions are subject to change. Historical economic and performance information is not indicative of future results.  

This document may not be reproduced or disseminated in whole or part without the prior written consent of Acadian Asset Management LLC. All rights reserved.

«