Examining some underappreciated benefits
• In order to fund liabilities, achieve retirement goals, or meet other investment objectives, many investors need the capital appreciation that equities can provide, but are concerned about downside risk.
• Despite the empirical history of low-volatility equity investing, many investors mistakenly equate low downside risk with low returns.
• By providing exposure to the potentially higher returns of the equity market, and at the same time mitigating downside risk, low-volatility investing addresses a significant obstacle to equity allocations.
• Low-volatility equity portfolios are typically constructed using historical data and can lack forward-looking estimates of risk and return, which fundamental research can provide.
Investors obligated to meet certain liabilities and investment objectives face a conundrum. While equities can provide the potential for capital appreciation that these investors need to help them meet their obligations, equities can also introduce volatility and downside risks. This combination is prompting investors to consider adding equities through an allocation to low-volatility (low-vol) equity investing— a strategy whose benefits some investors may not fully appreciate.
For many decades, investor unease with equity risk has not been addressed by investing strategies that have been more focused on following market benchmarks than managing return volatility. More recently, heightened global economic uncertainty—along with very low yields in the fixed income markets—has increased investor attention to capital preservation.
This, in turn, has highlighted the need for equity strategies that offer capital appreciation but also downside protection, to help manage equity risk via portfolio construction versus allocating to asset classes such as low-yielding bonds and/or cash equivalents.
In this paper, we demonstrate how managing portfolios that have lower volatility may enhance investment return potential, not diminish it. Moreover, its emphasis on capital preservation sets low-vol investing apart from other “smart beta” or “strategic beta” strategies that do not target downside protection.