Steps to dynamically reduce your equity risk

Both recent history and uncertainty about the future are reflected in changing attitudes to mitigating investment volatility.

In today’s low-growth environment, investors are being advised to allocate money into asset classes seeking higher returns and to take the necessary precautions to manage the extra associated risks.

To address the additional risks, there has been a recent proliferation of low-volatility equity funds.

The attraction of these is their aim to offer equity-like returns with reduced risk. This is beneficial for risk-budgeting purposes, and for employers concerned about the stability of funding levels.

Reducing risk without forfeiting return, however, is a challenge. To do this, fund managers need to deploy sophisticated low-volatility solutions.

Active v passive

One populist approach is simply to construct portfolios favouring stocks that have been less volatile in the recent past.

The belief is that the reduced volatility of the constituent stocks will be reflected in the overall volatility of the portfolio.

Active approaches do tend to be a little more expensive than passive, although this gap is less pronounced in the world of low-volatility portfolios

However, this simplistic approach is limited in effectiveness and capacity, and is not the best way of reducing overall portfolio volatility. The least volatile portfolio is not simply a combination of the least volatile stocks.

To exercise greater control over the portfolio’s volatility, actively managing the fund, regularly adjusting the constituents according to their constantly changing volatilities and correlations, and rebalancing accordingly, is essential.

The idea is to achieve both less volatility and higher net returns than passive strategies in the long run.

Estimating volatility accurately and reliably requires substantial skill and bespoke risk models. Passive approaches often use quite basic methodologies, based on simplistic or off-the-shelf risk models, with less focus on stocks’ correlations or on targeting the appropriate investment timescales.

To more effectively reduce volatility in an equity portfolio, it is necessary to adapt to changing market conditions and dynamically maintain the desirable portfolio characteristics in a manner that is not afforded by passive approaches.

As stocks’ individual volatilities and behaviour relative to other stocks change over time, active managers are able to adjust the construction of their portfolios based on prevailing market conditions. Passive approaches with infrequent reconstitution are more static and have less flexibility.

Furthermore, because of the simplistic methods frequently used to construct passive low-volatility funds, the resulting portfolios often overlap considerably.

This overlap, exacerbated by only a few passive options being in wide use, runs the risk of causing those obviously less volatile stocks - widely held by such portfolios - to become overvalued, thereby eroding the potential for future returns.

Managing costs

Many passive approaches to lower volatility are based on reducing volatility by fixed amounts, while hoping to achieve market-like returns in the long run. Yet these stated aims are often vague in terms of exactly how volatility will be reduced and what level of return will be achieved over what timeframe.

The more sophisticated active approaches, however, can offer more concrete, justifiable return targets – either to match or outperform the benchmark by specific amounts, while dynamically reducing volatility by as much as possible in differing conditions.

In addition, active approaches can incorporate techniques to generate sufficient alpha to cover the costs of fees and higher associated turnover.

This price differential, however, should be viewed in the context of investors’ reasons for investing in low volatility portfolios in the first place. For most, it is a combination of both risk reduction and return generation.

David Schofield is president of the international division at asset manager Intech