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Investor Knowledge 10 Minutes
Most investors either explicitly or implicitly understand the importance of risk-adjusted returns. This is shown by the fact that investors typically diversify to shield their portfolios from uncompensated risk. If risk was not an important consideration in portfolio construction, allocating all assets to a single security with the highest expected return would be quite common. Instead, nearly all investors are risk-aware and choose to hold other assets with lower expected returns in order to reduce the overall risk of their portfolio.
The evidence is clear when looking through an asset allocation lens: in addition to equities, nearly all institutional investors hold bonds, which typically carry a lower expected return but also incur lower volatility than equities. A mixed allocation to bonds and equities signals a general risk awareness and a degree of risk aversion. It's important for investors to get compensated for the risk they incur, and the Sharpe Ratio - a measure of risk-adjusted returns - serves as a barometer for that.
Risk/Return Profile of Low Vol Equities
Low volatility equities are no different than any other asset class and should be treated as such when considering strategic asset allocation. Based on long-term empirical evidence in every market around the world, low volatility equities deliver, over the long run, returns that are comparable with broad-based stock indices weighted by market capitalization (capitalization-weighted indices), with meaningfully less risk. Therefore, they have the potential to offer a more attractive way to gain exposure to equities from a risk-adjusted perspective.
Some investors may have difficulty grasping this concept because they don't look at low volatility equities in terms of their absolute risk, but rather in terms of their active risk against the market, which can lead to making erroneous strategic asset allocation decisions. This irrational human behaviour is a reason why the low volatility anomaly persists to this day.
Source: Kenneth R. French Data Library, Bloomberg Finance L.P., TDAM. As of May 31, 2024.
In addition, the potential ability of low volatility equities to protect on the downside may provide better capital preservation than cap-weighted indices on average during down markets. This is particularly helpful for institutional investors because it may allow them to better meet their future obligations in challenging market environments. Low volatility equities may help investors consistently pay the bills.
Source: Kenneth R. French Data Library, Bloomberg Finance L.P., TDAM. As of May 31, 2024.
Navigating the Uncertain Market Outlook
Low volatility investing has faced significant headwinds recently in comparison to cap-weighted indices, primarily due to a small number of companies driving cap-weighted returns and leading to highly concentrated outcomes both from a risk and return perspective. It would be great to predict the near-term performance of low volatility equities and the market, but an accurate forecast would require nothing short of clairvoyance. While low volatility equities offer some reasonable visibility into their future return due to the low dispersion of their outcomes, the market is much more volatile and offers much less visibility. With market risk concentration at an all-time high, the outlook for the market hasn't been this uncertain in the last two decades.
Low volatility equities are not benchmark-centric. They offer a distinct way to invest in equities, with much lower risk than the market. However, this comes at the cost of much higher benchmark-relative risk compared to cap-weighted indices. The very premise of low volatility is that risk reduction can be achieved without sacrificing long-term returns, but this also means that predicting whether low volatility will outperform the market over the short term becomes a much more difficult question to answer.
This is why instead of focusing on the short-term probability of outperforming an already frothy market, investors may be better served if they adopt a longer-term focus, get exposure to the equity market with less risk and obtain better risk-adjusted returns.
The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.
Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS.
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