Low Volatility Equity Strategies:
New and improved?
Jean Masson, Ph.D
Managing Director, TD Asset Management
January 2014
Low volatility equity strategies have been available to Canadian investors for several years now,
and new variations have emerged over this period. Understanding both the theoretical
foundation and the practical application of these approaches can be confusing, particularly with
the arrival of these new variations. It may be helpful to begin by appreciating the logic behind the
original low volatility equity strategy, and then move on to understanding the newer versions
before determining which variant might be most appropriate for your needs.
The low volatility anomaly
Low volatility strategies emerged as a theoretical challenge to the most commonly accepted
market model, the Capital Asset Pricing Model (CAPM), which forms the foundation of Modern
Portfolio Theory. CAPM, published in 1964 by William Sharpe, predicts that under a set of
standard assumptions (investor rationality, zero transaction costs, identical asset predicted
returns and variances and co-variances across investors) a capitalization-weighted portfolio of all
investable securities should provide the highest expected return per unit of risk, thus delivering
maximum market efficiency. Furthermore, within that cap-weighted market portfolio, CAPM
makes the intuitive prediction that stocks that contribute the most to portfolio risk, so-called “high
beta” stocks, should have higher expected returns than “low beta” stocks. Though this view of
the nature of the risk/reward relationship has formed the basis of academic thinking for decades,
actual market data has, over time, proven it false.
The historical pattern of equity returns is simply inconsistent with CAPM predictions. Historically,
risk has not been rewarded within equity markets. In fact, over complete market cycles the less
volatile stocks (i.e. less “risky” stocks) have delivered returns that, on average, exceed those of
the more volatile —or “riskier”— stocks. (See Figure A.) This pattern has become known as the
“low volatility anomaly” (anomalous in that it contradicts standard CAPM theory) and led to the
development of low volatility investment strategies.
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FIGURE A:
The graph below illustrates the return pattern of the constituents of the leading index of the
Toronto Stock Exchange (TSX) over the past 24 years. It is notable that, in spite of what CAPM
predicts, the least volatile stocks performed best over this period while the most volatile stocks
underperformed (In fact, their return was zero). This pattern is not limited to TSX-listed stocks; it
is similar for stocks that make up other leading equity indices as well. Empirical evidence from a
well-researched dataset of U.S. equity returns starting in 1927 has been dissected in many
professional and academic presentations1.
S&P/TSX Stocks (Dec 1999 - Dec 2013)
16%
14%
Annualized Returns
12%
10%
8%
6%
4%
2%
0%
-2%
Quintile 1-Least
Volatile
Quintile 2
Quintile 3
Quintile 4
Quintile 5 - Most
Volatile
Source: TDAM and Standard & Poor’s
1
Ann Marie Larson and Vadim Zlotnikov, “The Low-Beta Anomaly – Easy to Demonstrate, Harder to Explain,
Difficult to Exploit”, BernsteinResearch, 2012, examine a large dataset of U.S. equities from Factset covering 1926
through 2011. Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage:
Understanding the Low-Volatility Anomaly”, Financial Analysts Journal, 2011, analyze a broad set of U.S. equities
covering 1968 through 2008 from the Center for Research in Security Prices.
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The low volatility anomaly led to the launch of a number of low volatility funds, which aim to
exploit this empirical regularity. The first such fund in the Canadian marketplace was the TD
Emerald Low Volatility Canadian Equity Pool Fund Trust, launched in September 2009 by TD
Asset Management Inc. (TDAM). This Fund (and its retail counterpart) has been so successful
that TDAM recently capped it to new investors in order to strive to preserve its ability to deliver
superior risk-adjusted returns. Over its four year history, TD Emerald Low Volatility Canadian
Equity PFT has delivered returns far in excess of those generated by the cap-weighted index,
while exposing investors to 36% less return volatility.
Low volatility equities and pension plans
Clearly low volatility equities can offer higher risk-adjusted returns than cap-weighted equities.
This quality alone should make low volatility equities attractive to most investors. However, low
volatility equities do not outperform in all market conditions. They tend to underperform during
strong bull equity markets but outperform during severe bear markets. In other words, the lower
level of volatility dampens both the highs and the lows of returns. Low volatility equities may be
particularly well suited to investors who have longer investment horizons and a particular need
for capital preservation, such as pension plans. The tendency of low volatility equities to
underperform cap-weighted equities in the “state of plenty” and outperform in the “state of
penury” means plan sponsors may face a lower risk of having to recapitalize their pension plans
during the recessions that typically follow equity bear markets.
The less volatile returns of low volatility equity strategies may be particularly appreciated by
pension plans that are concerned about their asset-liability mismatch risk. Most mismatch risk in
a portfolio can be attributed to the equity component of the asset mix. Low volatility equities have
approximately only two thirds of the mismatch risk that capitalization-weighted equities have.
For institutional investors who want to preserve their funded status by remaining cautiously
focused on achieving optimal risk-adjusted returns, shifting from capitalization-weighted equities
to low volatility equities may be an attractive way to lower their asset-liability mismatch risk.
The evolution of low volatility strategies
Early low volatility funds focused primarily on minimizing expected return volatility, but there were
some differences in the complexity of the approach. For example, some funds, like ours,
employed risk models to monitor and exploit both individual stock volatility as well as pair-wise
correlations (the correlation between two stock returns) while others simply built portfolios of the
least volatile equities. Both our comprehensive portfolio approach and the less sophisticated
approach were focused on risk reduction. The implicit or explicit goal was to deliver expected
returns that were competitive with the capitalization-weighted index but with much lower risk.
This stands in sharp contrast with traditional active portfolio management where the portfolio
manager attempts to deliver superior returns while taking approximately as much risk as the
capitalization-weighted index.
The latest innovation in low volatility investing links the low volatility anomaly to other strong
empirical return patterns that are also inconsistent with the propositions of CAPM and market
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efficiency. These are the so-called value, smaller-cap, quality and momentum anomalies.
Strategies designed to exploit these anomalies are commonly known as “smart beta” because,
like low volatility approaches, they aim to achieve a better risk/return trade off than traditional
market capitalization indices (traditional beta). Unlike the low volatility approach, investing on the
basis of value, smaller-cap, quality, and price momentum operate by delivering higher expected
return. A strategy blending these smart betas essentially focuses first on risk reduction, then on
selecting less volatile stocks with greater return potential due to their value, smaller-cap, quality
and price momentum characteristics. Like the low volatility anomaly, these empirical
relationships occur regularly in most equity markets over complete market cycles.
Value and smaller cap. Defined in terms of the Book-to-Market multiple, the “value” anomaly
along with the “smaller-cap” effect2 exploits the fact that so-called “value” stocks and smaller
cap stocks tend to generate better returns as a group than the market-cap weighted stocks.
Quality. The quality anomaly3 suggests that stocks with lower risks of default and higher rates of
return on equity (ROE) have historically generated higher rates of return than the broad market.
This is sometimes called the “Buffet style” after Berkshire Hathaway’s Warren Buffet.
Momentum. The momentum anomaly is the pattern of stock leaders (measured over the recent
six to twelve month returns) continuing to lead the stock market over the next few months. In
other words, momentum ensures that these stocks continue to deliver higher returns than the
broader market in the shorter term.
It’s important to note that these anomalies are persistent but do not contribute equally to
performance over time. Portfolio managers must opportunistically tilt to the anomaly that they
consider most likely to benefit under current market conditions. An unsophisticated combination
of anomalies may result in significant unwanted exposures that may have disastrous
consequences if not properly understood. Therefore, when investing in these strategies, it is
essential to work with an experienced and sophisticated manager.
The strongest individual anomaly is the low volatility one; however, constructing an equity
portfolio inspired by all anomalies can lead to an investment solution that offers distinct
advantages over a simple low volatility portfolio. Integrating each of these characteristics into a
low volatility model can produce a portfolio that remains less risky, but benefits more from market
highs than a purely low volatility model.
As new strategies and models are released, it is ever more important to be aware of the
difference of how they work and what they can deliver. Though the labels may look the same,
there are many approaches to low volatility and smart beta that are quantitatively and
2
Eugene Fama and Kenneth French wrote a series of papers (1992, 1993, 2012) that detail the persistence of the
value and smaller-cap anomalies.
3
Benjamin Graham first introduced the quality anomaly in 1973.
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qualitatively distinct. Approaches can differ significantly in portfolio construction methodology,
constraints, and expected returns. Paying attention to these differences will ensure that you
make an informed choice.
FIGURE B:
TDAM’s Low Volatility Plus, the enhanced version of our original low volatility fund, is backed by
extensive historical back-tests. Test results suggest that by blending alpha signals from the
value, smaller-cap, quality and momentum anomalies with the risk-reduction characteristics of
the low volatility anomaly, this Fund can generate higher risk-adjusted returns than a strategy
focused solely on minimizing risk. As seen in Figure B, the benefits are likely to be most obvious
in rising equity markets as this strategy captures a greater portion of an up market than the
original strategy, while still outperforming in a down market. Using both the original low volatility
strategy combined with value and quality anomalies, our new funds provide both the downside
protection of low volatility investing and the potential for added value of value and quality
investing.
Source: TDAM and Standard & Poor’s
Note: The hypothetical performance information is shown for illustration purposes only and is not based on actual results,
which may vary.
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The statements contained herein are based on material believed to be reliable. Where such statements are based in whole or
in part on information provided by third parties, they are not guaranteed to be accurate or complete. The information does not
provide individual financial, legal, tax or investment advice and is for information purposes only. TD Asset Management Inc.,
The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or
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