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Historically, equities have offered superior long-term returns over assets such as bonds and cash—the well-known equity risk premium.  The problem for many investors is that equity returns have become exceedingly volatile.

The goal is to capture that equity risk premium with less volatility, said Andrew Mitchell, vice-president and portfolio manager with Phillips, Hager & North (PH&N), speaking last week at PH&N’s pension trustee education seminar in Toronto.

So how do investors reduce volatility in an equity portfolio? Mitchell offered five strategies, along with the challenges presented by each.

Asset allocation-based approaches
The conventional approach, tactical asset allocation, seeks to reduce total portfolio volatility by shifting the equity allocation at the right time, based on relative risk/reward expectations for various asset classes, said Mitchell. The main challenge with this approach is that timing markets is difficult, and being out of the market at the wrong time can be very costly.

More recently, a variety of new asset allocation approaches have been developed to alter the total asset mix to better compensate for the volatility of equities (e.g., risk parity). The drawback to this strategy is that it requires investors to sacrifice exposure to the equity risk premium or leverage the other asset class exposures to achieve target returns, he explained.

Using derivatives
Derivatives can be used to help mitigate volatility by purchasing portfolio insurance to hedge against losses. These strategies look to reduce volatility by holding another asset that tends to increase in value when equities are falling (e.g., put options or VIX futures).

These strategies have some merit; however, there is an ongoing cost to portfolio insurance that eats into long-term returns. Other pertinent challenges for include:

  • complexity, both structurally and legally;
  • operational and leverage risks;
  • illiquid Canadian equity derivatives markets; and
  • limited investor experience and/or comfort with executing these strategies.

Geographic diversification
By diversifying across various developed and emerging equity markets, said Mitchell, overall portfolio efficiency improves as risk is reduced while still attaining exposure to the equity risk premium. The basic premise, which has held in practice, is that global equity markets are not perfectly correlated.

However, recent experience has indicated some drawbacks. For one, the rise in equity market correlations with globalization has gradually diminished diversification benefits. Secondly, global diversification offers little protection from market crashes as correlations go to 1 during times of financial stress, he noted.

Nonetheless, geographic diversification still protects portfolios against sustained underperformance in a single geographic equity market.

Value or income strategies
Certain investment styles and strategies can produce a less volatile outcome as a by-product. Value or income strategies, for example, have delivered a material reduction in volatility in the past decade, said Mitchell. Some characteristics of these strategies suggest this could persist since, for example, value managers seek stocks where “the bad news is already being priced in.”

However, the challenge for investors is to recognize that volatility reduction is a by-product of most of these strategies as opposed to the primary mission. Consequently, investors need to assure themselves that they have adequately evaluated the investment process and the managers’ skill being considered to ensure that a less volatile portfolio is a sustainable expectation—and not just a coincidence.

Low-volatility equity strategies
While income and value strategies may (or may not) result in reduced volatility as a by-product of their investment process, minimizing volatility is the primary objective of low-volatility strategies. And, Mitchell added, these strategies mitigate volatility without any of the complexities of the above strategies.

According to modern portfolio theory, riskier assets should offer higher returns, and riskier individual securities should also offer higher returns within their overall asset class. But the latter part of that theory has been turned on its head, said Mitchell.

Research from PH&N and others has demonstrated that “risky stocks don’t deliver superior returns; they actually tend to deliver inferior returns.” Simply put, research suggests that no risk premium exists within equities as an asset class.

So, low-volatility equity strategies look to take advantage of this anomaly by turning the traditional investment objective on its head. Rather than maximizing returns relative to an equity index benchmark as the primary goal, these are long-only portfolios designed to build a diversified portfolio that will minimize volatility at any moment in time, said Mitchell, with the objective of generating superior risk-adjusted returns over a full market cycle.

These strategies also offer a number of positives for investors. The portfolios tend to emphasize stable stocks and businesses and a smaller weighting in more volatile/cyclical businesses such as resources. The focus on minimizing volatility tends to result in a more diversified portfolio (since these portfolios are not constructed with reference to a specific index). Finally, the resulting portfolio typically delivers a higher yield than the S&P/TSX.

“If we can achieve excess return in the least risky stocks,” Mitchell explained, “it results in a much more efficient portfolio.”

But while these strategies are generally easy to implement, they are not without their own challenges. The returns for these strategies tend to sharply outperform in falling markets, but lag in sharply rising markets, so investors need to prepare themselves for a different path of returns than a traditional index. Mitchell also indicated that traditional return-focused benchmarking is not enough with these strategies.

Since the main objective is to reduce equity volatility and deliver a more efficient portfolio, measures of reward to risk are more appropriate, he said.

Originally published on Advisor.ca

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