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.

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.