-AYs!

NInstitutional Investor eBook

Low
Volatility
Equities:
BUILDING SHARPER PORTFOLIOS

3PONSOREDBY

Sponsored eBook

Low Volatility Equities:

Building Sharper Portfolios
3

Why Higher Risk Does Not Always

Bring Higher Return

Lower Reconstitution Drag: The True

Source of Low Volatility Outperformance?

Optimizing Volatility-Managed Portfolios

10

Smart Volatility Management in a

Risk On/Risk Off World

13 Extending Volatility Reduction to

Global Equities
15 Conclusion
16 About INTECH
18 Disclaimer
19 Contact Information

2 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014

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Why Higher Risk Does Not

Always Bring Higher Return
Low volatility
portfolios
can beat
their benchmarks

ver time, portfolios of low volatility stocks tend to outperform both cap-weighted indexes and portfolios of high
volatility stocksa finding that appears to fly in the face
of normative equilibrium asset pricing models (i.e., higher

risk earns higher reward). In fact, low volatility equity portfolios may deliver
market-like returns for lower risk than their corresponding cap-weighted
benchmarks: for example, the S&P 500 Low Volatility Index outperformed
the cap-weighted S&P 500 Index by 89 basis points per year with 24%
lower risk for the past 25 years ended on December 31, 2013.

May 2014 Institutional Investor eBook Sponsored by INTECH Investment Management LLC 3

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Low
volatility
outperformance
is not an
anomaly

Assets in low volatility and managed volatility strategies grew more

than six-fold between 2010 and 2013, likely due to investors heightened sensitivity to downside risk after the financial crisis of 2008.
However, the outperformance of low volatility portfolios was identified
as far back as the 1970s, though more recently the reason for such
outperformance has been hotly debated, with many people pointing
to some kind of market anomaly.
Yet there is a much simpler explanation available, one that does not
require an anomaly: the outperformance of lower-volatility portfolios
may be a predictable consequence of the relationship between stock
volatility and rebalancing costs, with a compounding effect having a
significant impact on long-term returns.
Why does this distinction matter for investors? Because, while a
market anomaly may disappear in the future, a simple rebalancing and
compounding explanation provides reasons for the long-term persistence of low volatility equitys superiority over cap-weighted benchmarks. And more importantly, it paves the way toward systematic
approaches that allow for more efficient and dynamic portfolio-level
rebalancing. The ultimate goal may be chosen anywhere between the
following two extremes:
1. Higher portfolio return than the cap-weighted benchmark at a similar level of volatility; or
2. Similar returns to the benchmark with significantly reduced volatility,
which may allow for a higher allocation to equities for the same level
of total equity risk contribution. n

4 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014

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Lower Reconstitution Drag:

The True Source of Low Volatility
Outperformance?
Vassilios
Papathanakos, Ph.D.
Deputy Chief
Investment Officer,
INTECH Investment
Management

olatility-managed portfolios tend to suffer less

reconstitution drag in the course of regular portfolio rebalancing, compared to capweighted indexes and portfolios of high volatility

stocks, says Vassilios Papathanakos, Ph.D., Deputy Chief Investment Officer at INTECH Investment Management. Holding lower-volatility stocks within a given investable universe without style
drift, requires periodically selling stocks that have become riskier or
fallen out of the low volatility universe. Applied diligently over time,
this rebalancing rule may harness a compounding effect to create a
considerable performance advantage relative to the market.
According to Papathanakos, the full impact of diversification and

May 2014 Institutional Investor eBook Sponsored by INTECH Investment Management LLC 5

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Simple
ways to
understand
volatilitymanaged
portfolios

rebalancing on compound returns can be quantified using sophisticated mathematics. Fortunately, volatility-managed portfolios can
be understood using much simpler techniques. He offers this example: consider a portfolio that consists of one stock at any given
time, with a required market cap of at least $10 billion. Whenever
the market cap drops below $10 billion the investor must sell the
stock at a loss and then pay a premium to buy another stock that
has risen in value above $10 billiona double-whammy of performance drag that one could call sell low/buy high. (Exhibit 1)
Calculating the reconstitution drag for cap-weighted portfo-

EXHIBIT 1:

The cost of buying high and selling low

capitalization

Investors lose twice when the stocks

capitalization drops below $10 billion
suffering further underperformance when
they sell the old stock (solid line) and
missing outperformance (dotted line)
when they buy the new stock

$10B

sell new stock

buy cost
time

crossing event

sell cost
sell old stock

6 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014

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lios,1 one sees that broader universes suffer less: the reconstitution
drag for a portfolio of the largest 1,000 U.S. companies is 107
basis points less than a portfolio of the top 100 companies. (This

A broader
portfolio
universe
suffers less

drag is comparable to the 96-basis-point-a-year average compound outperformance the top 1,000 stocks experience over the
top 100.) If one looks at an index universe of the top 3,000 U.S.
stocks for the period January 1974 through December 2013:
A portfolio consisting of the bottom 20% of stocks in terms of
volatility would have outperformed the index by 33 bps annually
on a compound basis, with 38 bps lower reconstitution drag.
A portfolio consisting of the top 20% of stocks in terms of volatility
would have underperformed the index by 442 bps annually on a
compound basis, with an annual reconstitution drag of 382 bps.
These results suggest that high volatility stocks may actually
have higher arithmetic returns than the average stock on an individual basis, but still experience the same long-term (i.e., geometric) return as the rest of the stocks in the market. In particular, the
trading required to maintain style purity creates such a large performance drag (382 bps) that it overwhelms any stock-level advantagecontributing to most of the total annual underperformance
of 442 bps.
1

A simple equation for calculating the sell low cost for the portfolio of the top 100 companies is:

Capitalization of stock at month end

_____________________________

Capitalization of 100th-largest stock at month end

Assuming the sell low and buy high portions of the total cost are approximately equal one can estimate the
total reconstitution drag by simply doubling the sell low cost. The equation can be adjusted for the portfolio of
the top 1,000 companies in the obvious manner.

May 2014 Institutional Investor eBook Sponsored by INTECH Investment Management LLC 7

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Building
a true low
volatility
portfolio

Optimizing Volatility-Managed
Portfolios

hen it comes to volatility-managed portfolios,

investors have two main choices: low volatility strategies aim to match the cap-weighted
benchmark return while lowering portfolio risk

as much as possible; managed volatility strategies, by contrast,

have a two-fold objective of lowering portfolio risk, but at the same
time generating return in excess of the benchmark. In both cases
delivering on those objectives requires more than just picking the
lowest volatility stocks in the universe.
There is a big difference between a portfolio of low volatility
stocks and a low volatility portfolio, says Adrian Banner, Ph.D.,
Chief Executive Officer and Chief Investment Officer of INTECH.
The former just looks at the stocks at the individual level, while the
latter seeks to lower volatility at the portfolio level. In the latter case,
managers ought to take into account the volatility of each stock in
relation to every other stock in the portfolio.
This approach is very different from other rule-based weighting
schemes (e.g., cap-, equal-, fundamental-weighting) in which no
consideration is given to the riskiness of each stock. In absolute
volatility portfolioswhere the aim is to increase return per unit of
absolute risk at the portfolio levelthe contribution of each stock

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to total portfolio risk determines the weighting of that security.

And most importantly, because market risk is constantly changing, absolute volatility strategies require a dynamic approach. For
example, the low volatility portfolio of today most likely will not be
the optimal low volatility portfolio six months from now. By definition, then, low volatility and managed volatility strategies are not
buy-and-hold strategies. To be successful, they require dynamic
portfolio rebalancing.

Adrian Banner, Ph.D.

Chief Executive
Officer and Chief
Investment Officer,
INTECH Investment
Management

VIDEO: ADRIAN BANNER, PH.D. ON USING VOLATILITY AS A SOURCE OF RETURN

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Focus on
return
generation
versus risk
reduction

Smart Volatility Management in a

Risk On/Risk Off World

s market volatility increases, volatility reduction becomes both more achievable and more valuable,
says Banner. First, volatile markets are less riskefficient, making substantial reduction in risk more

readily achievable. Second, in volatile markets, risk reduction is more

valuable: the capital protection that comes with 10%-20% reduction
in volatility or drawdown may be invaluable in sustaining long-term,
compounded portfolio returns. In flat markets, investors do not need
as much downside protection and it may make sense to focus more
on return generation and less on risk reduction.
A dramatic demonstration of dynamic risk reduction, according
to Banner, occurs in managed volatility strategies that may more
closely resemble either a low volatility or a traditional core equity
portfolio, depending on the market levels of risk. Exhibit 2 shows that
in low-risk markets, as the managed volatility strategy seeks greater
excess return and less risk reduction, it ends up looking more like a
traditional core equity strategy. Alternately, in high-risk markets, when
risk reduction is more valuable, the managed volatility strategy seeks
larger risk reduction, reduced capital loss, and comparatively lower
excess returnlooking more like a low volatility strategy.
It is important to note that a dynamic risk-reduction approach

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does not need to depend on market timing, says Papathanakos. It

may rely exclusively on volatility estimates, which are far more reliable
than return estimates. He argues that if market volatility spikes, the
risk of managed volatility portfolios will already be lower than that of
the market because they are designed to be more risk-efficient than

Volatility
estimates
are more
reliable
than return
estimates

the market cap weighted benchmark. Furthermore, if the increase in

volatility persists, changes in volatility estimates will be reflected rather
promptly due to regular and systematic portfolio optimization and rebalancing, resulting in a shift to a more defensive positioning as the
strategy assumes the optimal posture for the new market regime.
These two portfolio design features allow managed volatility strategies
to both weather sharp volatility spikes and avoid being whipsawed.

EXHIBIT 2:

Hypothetical risk/reward characteristics

in two market regimes*

Annualized Absolute Return

Low-Risk
18%
Managed
Volatility
Strategy
13%

High-Risk
18%

Core Equity
Strategy
Index

13%

Low Volatility
Strategy

8%

8%

3%

3%

6%

10%

14%

18%

Managed
Volatility
Strategy

Index

Low Volatility
Strategy
6%

10%

Core Equity
Strategy

14%

18%

Annualized Standard Deviation

*Based on MSCI World index 1992-2013

May 2014 Institutional Investor eBook Sponsored by INTECH Investment Management LLC 11

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Risk metrics
can identify
market
shifts in a
timely way

Investors may gain two major benefits from focusing on risk reduction during periods when it is especially needed. Firstly, it may help
the portfolio outperform the market over the long term. Secondly, it
typically reduces capital loss in large market declines. The material
question here is: Is it possible to estimate the volatility structure of
the market accurately enough to achieve this outcome? According to
Banner and Papathanakos, the answer is a clear Yes! Risk metrics
measured by competent statistical methodologies can identify regime
shifts in the market in a timely fashion, especially if estimated regularly.
Exhibit 3 shows volatility reduction over time of a hypothetical managed volatility portfolio, versus the MSCI World Index: in volatile markets like the early and late 2000s, volatility reduction would spike to
as much as 25% to 35%, while in flat markets volatility reduction may
remain near zero. n
EXHIBIT 3:

Volatility reduction for a hypothetical managed

volatility strategy compared to the MSCI World Index

Volatility Reduction percentage

(36-Month Annualized Rolling)

35%

25%

15%

5%

-5%
94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

12

13

Year

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Extending Volatility Reduction

to Global Equities

ne can extend this dynamic risk reduction principle

i.e., reducing volatility where it matters mostto various asset classes, with emerging market equities being
the prime candidate. Emerging market equities (EME)

have outpaced developed market equities by approximately 3.8% per

year for the past 25 years, and many institutional investors believe
that this EME premium will persist well into the future. But variation in
annual returns for EME has been extraordinarily high.
According to Banner: EME, by virtue of its high risk and high correlation2 to developed equity markets, is a meaningful contributor to
Although not shown herein, the correlation between the S&P 500 Index and MSCI EM Index has been steadily
increasing. Based on two-year rolling monthly returns, the correlation between the two exceeded 0.8 for the period
ending December 31, 2012.
2

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The
importance
of emerging
markets
in portfolios

portfolio risk at the global equity structure level. And with steady increases to the EME allocation, the success or failure of the global
equity allocation becomes more and more dependent on the performance of the emerging markets portion of the portfolio. The combination of high performance expectations and high volatility makes EME a
prime target for risk reduction through managed volatility strategies.
Managed volatility strategies could have made a particularly meaningful difference during the 25-year period from 1988 to 2012, when
the realized volatility for the MSCI Emerging Markets Index was 24%,
based on annualized monthly gross returns in U.S. dollars. Exhibit 4
shows the potential risk impact of replacing a traditional EME strategy
with a managed volatility EME strategybased on risk forecasts from
Callan Associates. It shows that a managed volatility EME strategy
could reduce both overall global equity risk, as well as the risk contribution from EME. n
EXHIBIT 4:

EME managed volatilitys contribution to risk in the

global equity structure
Allocation within Global Equities
12%
EME

12%
EME MV

Decrease

33%
EME

33%
EME MV

Decrease

Global Equity
Portfolio Risk

15.4%

14.8%

0.6%

16.8%

15.0%

1.8%

Contribution to Global
Equity Portfolio Risk

14.9%

11.4%

3.5%

43.6%

35.7%

7.9%

Description

Source: Callan Associates and Janus Capital. Risk is defined by standard deviation. Risk allocation represents estimates
based on variance and correlation forecasts from Callan Associates 2012 Capital markets Assumptions.

14 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014

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Conclusion

olatility reduction is both possible and highly beneficial

to todays global equity investors, potentially delivering
index-like return for significantly lower riske.g., up to
60% lower risk than the MSCI All Country World Index.

But more importantly, with dynamic risk reduction, managed volatility strategies may deliver excess return over the cap-weighted
benchmark, while also lowering drawdowns in high-risk, high volatility market regimes.
We believe that the mechanism driving outperformance in low
volatility stock portfolios is both simple and straightforward. However, in our view, building low volatility portfolios is not the same
as simply constructing portfolios of low volatility stocks. This is
because an understanding of risk at the portfolio leveland an explicit, reliable source of alpha to pay for the required turnoverare
necessary components of realistic implementations. Such a rigorous, rules-based approach to portfolio construction can give investors both the performance and risk reduction they seek, when and
where they need it most.

May 2014 Institutional Investor eBook Sponsored by INTECH Investment Management LLC 15

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INTECH: A Pioneer in
Equity Portfolio Management

NTECH specializes in large-cap equity management for institutional investors, and has been at the forefront of both the theory
and practice of equity portfolio construction for more than 25
years. Long before the term smart beta was first coined INTECH

had been using the power of mathematics to construct portfolios as a

risk-managed alternative to capitalization-weighted equity portfolios.
INTECHs goal has always been to generate returns greater than the
benchmark index while minimizing relative or absolute risk. The same
investment process has been applied to all of its large-cap equity portfolios since the firms inception in 1987.
INTECH applies this methodology to a diverse range of strategies
in U.S., Global, European and Emerging Market equity markets. Different relative return targets, of between 1% and 4%, can be specified, with risk objectives tailored to either minimize tracking error or
portfolio variance, depending on an investors return objectives and
risk budgets. In this way, INTECH strategies can be used to perform
a variety of roles in an overall equity allocation: U.S., global, non-U.S.,
emerging markets, enhanced, core, growth and value, and low and
managed volatility, all within a risk-managed framework. n

16 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014

Smart Volatility Management

in a Risk On/Risk Off World

Conventional wisdom suggests that investment solutions that

require market timing to manage volatility are fraught with peril.
By constructing a portfolio based on the level of market volatility
rather than return forecasts, its able to adapt more readily to
changing market conditions. The result: a portfolio with greater
balance between capital preservation and capital appreciation.
For more than 25 years, INTECH has been building portfolios
that adapt to fast-changing and volatile markets. To learn how
INTECH can provide risk management when you need it most,
call us at 800.227.0486 or visit www.intechjanus.com.

A Janus Capital Group Company

Past performance does not guarantee future results. Investing involves risk, including
XFWXDWLRQLQYDOXHWKHSRVVLEOHORVVRISULQFLSDODQGWRWDOORVVRILQYHVWPHQW

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Disclaimer
Information

he views expressed in this article are subject to change

based on market and other conditions. The views are for
general informational purposes only and are not intended
as investment advice, as an offer or solicitation of an offer

to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. This information should not be used as the sole basis for investment decisions.
Past performance cannot guarantee future results. Investing involves
risk, including the possible loss of principal and fluctuation of value.
The hypothetical illustrations contained herein do not represent the
performance of any particular investment. Advisory fees and other
expenses are not contemplated in the hypothetical illustrations. n

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Contact
Information
John Brown
Head of Global Client Development
INTECH Investment Management
jbrown@intechjanus.com
Susan Oh
Head of US Institutional
Janus Capital Institutional
susan.oh@janus.com

19 Institutional Investor eBook Sponsored by INTECH Investment Management LLC May 2014