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Low Volatility Portfolios

In a low return, sideways drift environment, some Investment Managers may be challenged to add value beyond the benchmark index. Individual Investors can access index-like returns through lower-cost ETFs while Institutional Investors can access index-like returns through massive index pools. So Investment Managers will have to be more creative to retain and attract investors.

One of the more interesting (new … ish) innovations are Low Volatility Portfolios (LVPs).

LVPs focus on risk mitigation. Basically, an LVP reduces (or removes) the impact of the most volatile stocks. Here’s how.

Whereas traditional benchmark portfolios are built on the basis or market valuation (capitalization) of each stock, an LVP is constructed by analysing the amount of risk each security contributes to the portfolio.  The pool from which securities are selected is the same (the S&P/TSX in Canada or S&P 500 in the U.S.) but the selection criteria for the LVP are risk-based. (After a whole lot of math), the optimum portfolio has a stock allocation that is expected to deliver less volatile returns.

For example, where the TSX has a 3% weighting to Barrick Gold, the LVP might have a weighting of ½ that. Where RIM has a weighting of nearly 4%, the LVP might have a 0% weight.

A market value (capitalization) based benchmark will over-weight larger or a more recently ‘successful’ stocks (think Nortel).  Expect a LVP, on the other hand, to exhibit a more ‘value’ tilt, towards less cyclical sectors and with a higher dividend yield. Because the LVP is less benchmark-sensitive and focuses more on risk mitigation, it may also lean towards smaller and mid-cap stocks and away from large cap (Banks, Energy and Materials behemoths).

In a bull market the LVP will likely underperform a traditional benchmark-based portfolio because the LVP under-weights dramatic stock movement. Dramatic movement is ‘smoothed’ … just like investors like it.

Why would an investor be interested?

Recall that a portfolio with a small cap and value tilt will outperform over longer periods. And, for the math geek, (and readers of this/previous Blog posts), smoother, more stable returns compound faster over time.

Further, over long periods, there is only marginal return difference between less volatile and more volatile stocks. So why accept the volatility? Put another way, volatility can be 20% – 30% less (per some studies) in a LVP for roughly the same average return (as a benchmark index). Again, more consistent returns compound faster.

Therefore, LVPs will appeal to the risk-focussed investor.

Individual investors will (eventually) have access to LVPs through an ETF provider.

References: Squeeze Play’, CFA magazine, Nov-Dec 2010, TD Asset Management, Analytic Investors, Bank of Montreal Asset Management, Hillsdale Investment Management Inc., MSCI

Next time?

130/30 Portfolios.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan


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