What is a Martingale?
Low volatility equity strategies, sometimes referred to as managed volatility or minimum variance strategies, seek to deliver equity market returns with significantly less return variability than the capitalization-weighted market index. Compared to traditional equity, they have similar return potential, but vary on the risk dimension. Low volatility strategies provide a smoother pattern of returns over time, but have larger deviations (tracking error) from the capitalization-weighted index.
Studies appearing as early as the 1970s using equity market data going back as far as the 1930s highlight the shortcomings of the capital asset pricing model and its prediction of a linear relationship between risk and return. Numerous studies since then have noted the unusually good performance of low risk stocks across U.S. and international equity markets alike. Unlike the positive relationship between risk and return across asset classes, the relationship within the equity market has followed a different pattern. Stocks with below-average volatility have performed better than expected, while stocks with the highest volatility have performed much worse than expected. As a result, it has been possible to build portfolios tilted towards low volatility stocks that have had market-level returns or better and much lower volatility, suggesting the existence of a low volatility alpha.
Not only do low volatility strategies present an attractive risk/reward profile, but they may also be a good match for the liability structure of many investors. They provide the high return potential of equities with less of the volatility penalty. This can enable a higher allocation to equities or conserve the risk budget to be allocated to other alpha seeking strategies that entail more volatility.
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