Is Volatility the New Black?

Imagine you're at an investment conference. Around you, portfolio managers are discussing their strategies. They're not talking about returns; they're discussing volatility. It's like the financial world has embraced a new mantra: "Low volatility is the new high return." But why? And what does this mean for your portfolio?

Why Volatility Matters Now

In today's markets, managing risk isn't just about avoiding losses—it's also about avoiding unnecessary fluctuations that can sap investor confidence and lead to poor timing of buys and sells. This shift in focus is driven by a few factors:

1. Retail Investor Sentiment: The rise of retail investors has brought a preference for stability over big swings, even at the cost of slightly lower returns. 2. Institutional Pressure: Pension funds and other institutional investors are increasingly looking to minimize volatility to protect their beneficiaries' benefits. 3. Benchmark Awareness: Managers are keenly aware that they're being judged against benchmarks. A portfolio that's less volatile but lags the benchmark can appear riskier on a relative basis.

Historical Context: Volatility as the New Alpha

This focus on volatility is a departure from the past, when managers were primarily judged on absolute returns (alpha). Now, low volatility is seen as a valuable outcome in itself. It's almost become the new alpha.

Understanding Low Volatility Investing

Low volatility investing isn't about parking your money under a mattress. It's about identifying securities that are less likely to experience big price swings and combining them in a way that maintains diversification. Here's how it works:

- Security Selection: Stocks with lower beta (a measure of systemic risk) and higher idiosyncratic risk (company-specific factors) tend to have lower volatility. - Portfolio Construction: By combining these securities, you can create a portfolio with lower overall volatility while maintaining diversification.

Misconception: Low Volatility Means Low Return

A common misconception is that low volatility strategies must sacrifice returns. While it's true that these portfolios may not beat the market in bullish periods, they often outperform during market downturns due to their lower drawdowns.

The Data Behind Low Volatility

Let's look at some data from a 10-year backtest (2008-2017) of the MSCI World Index. We'll consider two portfolios: one that sorts stocks by volatility and selects the lowest 30%, and another that sorts by return and selects the top 30%.

| Metric | Volatility-Sorted Portfolio | Return-Sorted Portfolio | |----------------|----------------------------|------------------------| | Cumulative Return | +168.5% | +217.4% | | Standard Deviation (Volatility) | 11.9% | 20.3% | | Maximum Drawdown | -40.2% | -53.9% |

As you can see, the volatility-sorted portfolio had lower volatility and a shallower maximum drawdown, although its cumulative return was lower.

Portfolio Implications: C and AGG

Let's consider two assets: C, the iShares MSCI EAFE ETF, which tracks developed markets outside North America; and AGG, the iShares Core U.S. Aggregate Bond ETF, which tracks U.S. investment-grade bonds.

- Conservative Approach: Allocating 70% to AGG and 30% to C can provide a stable return with relatively low volatility. - Moderate Approach: A 50/50 split between C and AGG offers moderate returns with reasonable volatility. - Aggressive Approach: 70% in C and 30% in AGG provides higher potential returns but at the cost of higher volatility.

Risks and Opportunities

While low volatility strategies can protect against market downturns, they also come with risks:

1. Lower Potential Returns: In bullish markets, these portfolios may lag behind higher-risk strategies. 2. Sector Concentration: Low volatility stocks tend to be concentrated in certain sectors (e.g., utilities and consumer staples).

Opportunities include:

1. Enhanced Risk-Adjusted Returns: During market corrections or bear markets, low volatility portfolios can outperform. 2. Improved Investor Sentiment: Stable performance can boost investor confidence and reduce the likelihood of panic selling.

Practical Implementation

To implement a low volatility strategy:

- Stock Selection: Screen for stocks with lower beta and higher idiosyncratic risk using tools like Bloomberg Terminal or FactSet. - Portfolio Construction: Combine securities to achieve diversification and maintain your desired level of volatility. - Timing Considerations: Low volatility strategies can be useful in late-stage bull markets or uncertain economic conditions.

Implementation Challenges

1. Data Availability: Obtaining reliable historical data on idiosyncratic risk can be challenging. 2. Transaction Costs: Frequent trading to maintain low volatility can lead to high transaction costs.

Your Action Plan

So, what's your next step? Here are some actions you can take:

1. Assess Your Risk Tolerance: Understand how much volatility you're comfortable with and adjust your portfolio accordingly. 2. Evaluate Your Current Portfolio: Check if your portfolio's volatility aligns with your risk tolerance and adjust as needed. 3. Consider Low Volatility ETFs or Mutual Funds: These can provide instant exposure to low volatility strategies without the hassle of individual stock selection.