In recent years, there has been meaningful uptake in low volatility equity strategies by institutional investors globally. While the objective of the low volatility style – achieving equity-like returns with lower levels of volatility – may be well understood, the challenge of how to properly measure and evaluate their effectiveness using an appropriate performance benchmark has proven more difficult.

This paper examines different approaches to benchmarking low volatility equity strategies, including their use in the context of an investor’s total portfolio. While there is no one-size-fits-all solution to overcoming this challenge, we will discuss the common benefits and drawbacks of each potential performance benchmark. Importantly, we also emphasize that investors should clearly identify, discuss, and document their investment beliefs and performance expectations when allocating to a low volatility equity strategy to ensure that sound long-term strategic decisions are made for the total portfolio despite the existence of benchmarking challenges.

Introduction

While not all low volatility equity strategies are constructed in the same manner and investors’ reasons for implementing these strategies within their portfolios may differ, their general objective is to deliver strong risk-adjusted returns at a lower level of absolute risk (with risk defined as the volatility of returns). In support of this objective, low volatility equity strategies will typically aim to:

• Invest in “defensive” stocks of stable, mature businesses that generate reliable earnings and cash flow streams, while maintaining low exposure to stocks in higher-growth or more cyclical companies or sectors.
• Deliver “equity-like” returns over time despite exhibiting lower volatility than the broad market, due to the belief and evidence that suggests a low volatility premium exists.¹
• Provide strong downside protection, at a cost of participating to a lesser extent during strong market rallies, thereby achieving a smoother path of returns over time as compared to broad market indices.

Once an investor has determined that a low volatility equity strategy is well suited to their objectives and has decided to implement such a strategy, a new consideration arises: how should they go about measuring and evaluating its effectiveness in achieving its objectives?

Identifying a valid benchmark

A valid benchmark has been described as one that is unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable.² Specific definitions for these terms as they apply to a benchmark are described below:

• Unambiguous: The individual securities and their weights within the benchmark should be clearly identifiable.
• Investable: It must be possible to replicate and hold the benchmark to earn its return (at least gross of expenses).
• Measurable: It must be possible to measure the benchmark’s return on a reasonably frequent and timely basis.
• Appropriate: The benchmark must be aligned with the manager’s investment style or area of expertise.
• Reflective of current investment opinions: The manager should be familiar with the securities within the benchmark and their factor exposures, and should be able to develop an opinion regarding their attractiveness as investments. In other words, they should not be given a mandate of obscure securities.
• Specified in advance: The benchmark must be constructed prior to the evaluation period so that the manager is not judged against benchmarks created after the fact.
• Accountable: The manager should accept ownership of the benchmark and its securities and be willing to be held accountable to the benchmark

While benchmarks that meet all of these criteria are generally available for most strategies that invest in equities and fixed income, investors have had to be flexible on some of these criteria when selecting benchmarks for other asset classes, such as private investments. In order to properly capture the objectives of a low volatility strategy and assess its success in delivering on performance expectations, we believe similar concessions and a little creativity may be required.

The challenge with using the returns of a broad capitalization-weighted index as a benchmark

As described above, the objective of low volatility equity strategies is to deliver strong-risk adjusted returns at a lower level of absolute risk. To achieve this objective, these strategies typically do not apply positioning constraints relative to broad market indices in their construction process, and do not explicitly aim to outperform broad market indices purely from a returns-based perspective. As a result, these portfolios can differ meaningfully from broad market indices when it comes to positioning and key characteristics, and can display considerable tracking error in the short term. Thus, while a traditional broad market index is easily understood, widely used as a benchmark for many equity strategies, and an investor can seamlessly group performance into top-level multi-asset portfolio reporting, the misalignments referred to above can provide the wrong signal to investors as to whether or not the low volatility strategy is meeting its objectives.

To illustrate the effects of this challenge over time, Figure 1 shows the historical one-year relative return of the MSCI World Minimum Volatility Index (chosen as an imperfect proxy to represent the low volatility equity style) vs. the MSCI World Index. It is evident that the two have deviated substantially, both positively and negatively, over the more than thirty years illustrated. To put it another way, these are high tracking error strategies relative to cap-weighted indices. We would argue that during the periods where the MSCI World Minimum Volatility Index has lagged the MSCI World Index, this relative underperformance does not provide any insight into whether low volatility equity strategies succeeded or failed to meet their objective. Likewise, during the periods of strong outperformance, returns alone cannot establish that these strategies delivered what they set out to. Given the strong tendency of low volatility performance to mean-revert relative to cap-weighted indices, these false signals can be quite dangerous, as they could potentially cause an investor to throw in the towel at what, in hindsight, is exactly the wrong time.

Figure 1: Rolling 1-Year Relative Performance

MSCI World Minimum Volatility Index vs. MSCI World Index (C$)

Source: RBC GAM, MSCI. March 31, 1989—March 31, 2022.

In an attempt to more accurately represent the risk and return profile of low volatility equity strategies, the following sections highlight three potential benchmarks to consider in lieu of or in addition to benchmarking to the returns of a broad cap-weighted index.

Additional resources