314151-intech

-AYs!NInstitutional Investor eBook

Low Volatility Equities: BUILDING SHARPER PORTFOLIOS

3PONSOREDBY

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

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3 Why Higher Risk Does Not Always Bring Higher Return

5 Lower Reconstitution Drag: The True Source of Low Volatility Outperformance?

8 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

Low Volatility Equities: Building Sharper Portfolios

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

Over time, portfolios of low volatility stocks tend to outper-

form 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.

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Why Higher Risk Does NotAlways Bring Higher Return

Low volatilityportfolios can beattheir bench-marks


Assets in low volatility and managed volatility strategies grew more

than six-fold between 2010 and 2013, likely due to investors height-

ened 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 persis-

tence of low volatility equitys superiority over cap-weighted bench-

marks. 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 simi-

lar 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

Low volatility

outperfor-mance

is not an anomaly

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Volatility-managed portfolios tend to suffer less

reconstitution drag in the course of regu-

lar portfolio rebalancing, compared to cap-

weighted indexes and portfolios of high volatility

stocks, says Vassilios Papathanakos, Ph.D., Deputy Chief Invest-

ment Officer at INTECH Investment Management. Holding low-

er-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

Lower Reconstitution Drag: The True Source of Low Volatility Outperformance?

Vassilios Papathanakos, Ph.D.

Deputy Chief Investment Officer,INTECH Investment Management

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EXHIBIT 1: The cost of buying high and selling low

rebalancing on compound returns can be quantified using sophis-

ticated mathematics. Fortunately, volatility-managed portfolios can

be understood using much simpler techniques. He offers this ex-

ample: 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 perfor-

mance drag that one could call sell low/buy high. (Exhibit 1)

Calculating the reconstitution drag for cap-weighted portfo-

Simple ways to

understandvolatility-managedportfolios

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time

cap

italiz

atio

n

crossing event

$10Bbuy cost

sell cost

sell old stock

sell new stock

Investors lose twice when the stocks capitalization drops below $10 billionsuffering further underperformance when they sell the old stock (solid line) and missing outperformance (dotted line) when they buy the new stock


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

drag is comparable to the 96-basis-point-a-year average com-

pound 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 indi-

vidual basis, but still experience the same long-term (i.e., geomet-

ric) return as the rest of the stocks in the market. In particular, the

trading required to maintain style purity creates such a large per-

formance drag (382 bps) that it overwhelms any stock-level advan-

tagecontributing to most of the total annual underperformance

of 442 bps. n

A broaderportfoliouniversesuffers less

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_____________________________ - 1 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.



When it comes to volatility-managed portfolios,

investors have two main choices: low volatil-

ity 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

Building a true low

volatilityportfolio

Optimizing Volatility-Managed Portfolios

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to total portfolio risk determines the weighting of that security.

And most importantly, because market risk is constantly chang-

ing, 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 defini-

tion, then, low volatility and managed volatility strategies are not

buy-and-hold strategies. To be successful, they require dynamic

portfolio rebalancing. n

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


As market volatility increases, volatility reduction be-

comes both more achievable and more valuable,

says Banner. First, volatile markets are less risk-

efficient, 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

Focus on return

generation versus risk

reduction

Smart Volatility Management in a Risk On/Risk Off World

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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

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 re-

balancing, 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.

Volatility estimatesare more reliablethan return estimates

EXHIBIT 2:

Hypothetical risk/reward characteristics in two market regimes*


Low-Risk High-Risk18%

13%

8%

3%6% 6%10% 10%14% 14%18% 18%

18%

13%

8%

3%

Annualized Standard Deviation

Ann

ualiz

ed A

bso

lute

Ret

urn

*Based on MSCI World index 1992-2013

Managed Volatility Strategy

Managed Volatility Strategy

Core Equity Strategy

Core Equity Strategy

Index

Index

Low Volatility Strategy

Low Volatility Strategy


Investors may gain two major benefits from focusing on risk reduc-

tion 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 man-

aged volatility portfolio, versus the MSCI World Index: in volatile mar-

kets 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

Risk metrics can identify

market shifts in a

timely way

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EXHIBIT 3:

Volatility reduction for a hypothetical managed volatility strategy compared to the MSCI World Index

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

Vola

tility

Red

uctio

n pe

rcen

tage

(36-

Mon

th A

nnua

lized

Rol

ling)

Year


Extending Volatility Reduction to Global Equities

One can extend this dynamic risk reduction principle

i.e., reducing volatility where it matters mostto vari-

ous 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 cor-

relation2 to developed equity markets, is a meaningful contributor to

2 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.



portfolio risk at the global equity structure level. And with steady in-

creases to the EME allocation, the success or failure of the global

equity allocation becomes more and more dependent on the perfor-

mance of the emerging markets portion of the portfolio. The combina-

tion 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 mean-

ingful 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 contri-

bution from EME. n

The importance

of emerging markets

in portfolios

EXHIBIT 4:

EME managed volatilitys contribution to risk in the global equity structure

Allocation within Global Equities

Description12%EME

12% EME MV

Decrease33% 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%

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.

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Volatility 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 vola-

tility strategies may deliver excess return over the cap-weighted

benchmark, while also lowering drawdowns in high-risk, high vola-

tility market regimes.

We believe that the mechanism driving outperformance in low

volatility stock portfolios is both simple and straightforward. How-

ever, 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 ex-

plicit, reliable source of alpha to pay for the required turnoverare

necessary components of realistic implementations. Such a rigor-

ous, rules-based approach to portfolio construction can give inves-

tors both the performance and risk reduction they seek, when and

where they need it most. n

Conclusion

Allocation within Global Equities

Description12%EME

12% EME MV

Decrease33% 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%


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INTECH: A Pioneer in Equity Portfolio Management

INTECH specializes in large-cap equity management for institu-

tional 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 port-

folios 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. Dif-

ferent relative return targets, of between 1% and 4%, can be speci-

fied, 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

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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

Smart Volatility Management in a Risk On/Risk Off World

DisclaimerInformation

The 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 sponsor-

ship of any company, security, advisory service, or fund. This informa-

tion 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

[email protected]

Susan Oh

Head of US Institutional

Janus Capital Institutional

[email protected]


TOCWhy Higher Risk Does Not Always Bring Higher ReturnLower Reconstitution Drag: The True Source of Low Volatility Outperformance?Optimizing Volatility-Managed PortfoliosSmart Volatility Management in a Risk On/Risk Off WorldExtending Volatility Reduction to Global EquitiesConclusionAbout INTECHDisclaimerContact Information

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