“We all know the basic premise — that assets with more risk should generally be compensated with higher returns. The more risk you take, the more return you should expect. The empirical reality is that isn’t really true,” said Treacy, an institutional portfolio manager at Fidelity Investments Inc., during his session.
He argued that the capital asset pricing model, which describes the relationship between systematic risk and expected return, failed to explain the long-term strength of low-volatility stocks. Over the past 25 years, he pointed out, low-volatility stocks have outperformed others, suggesting that risk isn’t being properly compensated.
When the Fidelity team first became aware that this pricing nondisjunction could be seen in the index, they set about gathering a stronger, longer-term data set.
“We actually used the U.S. equity markets, mainly because we could get more there than elsewhere, and we looked over 80 years. Then, we built minimum variance portfolios, selecting for the lowest volatility stocks plus those that are uncorrelated. It showed that the minimum variance portfolios (low-volatility) consistently resulted in lower risk and better risk-return ratios versus the market.”
With these findings, the Fidelity team began figuring out a strategy to turn this pricing anomaly into a strategy that could deliver these benefits for clients. In the end, they settled on a strategy to combine insights from Fidelity’s fundamental research team, and discipline portfolio construction to build a low-volatility portfolio.
“By combining low volatility strategies with other investment strategies it can make for a more efficient equity allocation in general over the long term. However, it’s not perfect. . . . There are aspects of low volatility strategies one should be aware of — one’s short-term relative returns. On a one-year basis, rolling relative returns of low-volatility stocks are often beaten by the market. You see pretty dramatic underperformance when the market has appreciated quite strongly.”
The imperfections in the low-volatility strategy could be most recently seen during the hot markets of mid-2020 through late 2021. Despite this, Treacy said he believes that, by combining low volatility equities with other alternatives, pension plan sponsors can create a more efficient equity allocation — one that may be especially appealing.
“The one thing about low-volatility investing that really comes through is the downside protection it offers. Lower risk portfolios tend to be better in down markets — and that’s important. As many plan sponsors know, you have to pay benefits, meaning your real enemy is capital deterioration. If you look at the MSCI indices, it shows the minimum volatility index has about 60 per cent downside capture over the last 30 years — and about 72 per cent upside participation.