De-risking has become the holy grail of pension investment management. On the DB side, one of the major reasons for plan closings has been the uncertainty caused by funding volatility. On the DC side, planned retirements were postponed when the markets dropped in 2008. There is a great need to lower the uncertainty while maintaining the return.
Liability driven investment techniques have focused on managing the assets more closely to the needs of the liabilities. Since the major economic factor driving most plans’ funding and accounting risk is interest rates, this typically means managing bonds to more closely match the liabilities. However, most DB plans will continue to invest in “risky” return-seeking assets that are largely unmatched with their liabilities because they need the higher expected returns associated with these assets. Stocks will continue to be a major component of the risky asset portfolio. For a plan with a typical 60/40 stock/bond asset mix, over 90% of the volatility is expected to come from the stock portion of the portfolio. So getting the bond portfolio more closely matched with the liabilities is likely to have very little overall benefit.
Alternatively, if we can gain exposure to stock markets and achieve the needed market return while building a portfolio that is less volatile than the market, we may be able to significantly lower funding volatility without giving up on market return. This is the aim of a lower-volatility stock portfolio approach.
Does it work? It is certainly possible to construct such a portfolio just by investing in the right types of companies. In investment parlance, these would be considered lower beta stocks. Such a portfolio would be expected to decline less in a down market but increase less in an up market.
However, classical investment theory would tell us that this approach should provide a lower long-term return. Investors are risk averse. The only reason investors buy stocks that are systematically more volatile is if they are expected to provide higher returns. But proponents of low-volatility investing point to a lot of back-testing—and some actual results—that indicate return is not being sacrificed by investing in a lower-volatility portfolio.
Maybe the positive results shown by low-volatility investing merely reflect the selected time periods, and the fact that we seem to have suffered more than our share of down markets recently. Or maybe low-volatility investing works because investors are not risk averse, or the definition of risk is different than just absolute volatility.
I am reminded of an analysis published by a large investment firm 11 years ago, when Nortel was dominating the Canadian stock market. The firm correctly observed that Nortel stock seemed overvalued, but concluded that it had to allocate at least 10% of its Canadian equity portfolio to Nortel stock, because to invest less in Nortel was too “risky.” This definition of “risky,” meaning different from the index, is diametrically opposed to “risky,” meaning high absolute volatility.
It is volatility relative to the index, rather than absolute volatility, that seems to dominate much of institutional investor behavior. Many pension funds that invest in index funds do so because they consider the index funds to be lower risk, even though the index funds have higher absolute volatility than most active portfolios, and certainly no greater correlation with the plan’s liabilities.
Perhaps it is the dominance of benchmarks in institutional investment that has created the market inefficiency that low-volatility investing seeks to exploit. And while the marketing claims (“all the returns of the market with only two-thirds the risk”) seem like a free lunch that won’t last, as long as a large percentage of institutional investors continue to buy index funds or employ investment managers who manage closely to the index, low-volatility investing may provide a sustainable advantage to those funds that need to invest in risky assets, but want lower funding volatility.
Because most pension investors would greatly benefit from lower equity volatility, this is an approach that is well worth considering. It is not an attractive approach, however, if you are looking to beat the market, or if you are bothered by periods of significant underperformance relative to the cap-weighted market index.
If you believe your investment manager can beat the market (add alpha) this approach is not for you, because the stocks are being selected more on the basis of expected volatility than expected return relative to other stocks. In fact, low-volatility investing may be viewed as a form of fundamental indexing—i.e. designing a better index and then passively matching it. The better index, in this case, is one that will provide considerably lower volatility than the standard cap-weighted indices.
If you want your manager to have low tracking error, relative to the cap-weighted market index, you also might want to avoid low-volatility investing. As stated above, seeking lower absolute volatility and lower relative volatility lead to very different portfolios. A low-volatility portfolio will likely end up greatly underperforming a cap-weighted market index in some time periods.
But for plan sponsors who want to manage funding risk rather than just chasing returns, and who are not slaves to their benchmarks, low-volatility investing may provide a useful additional tool to the mix.