After seven years of stock market gains and the rising duration risk across fixed income assets, many institutional investors have tempered their return expectations. Increasingly, investors are turning their attention on how to best achieve equity-like returns with less risk or, in the case of insurers, lower solvency capital requirements.
To do so, they consider various strategies:
Allocating to low-volatility indices. Interest in these assets has been underpinned by the so-called low-volatility anomaly. Contrary to the proposition that investors realise above-average returns in an efficient market only by taking above-average risks, high-beta and high-volatility stocks have long underperformed low-beta and low-volatility stocks.
Baker, Bradley and Wurgler argue that this anomaly may be partly explained by the fact that the typical institutional investor’s mandate to beat a fixed benchmark discourages arbitrage activity in both high-alpha, low-beta stocks and low-alpha, high-beta stocks.
Conversely, my colleague Wei Ge, Ph.D. and others have questioned the existence of the low volatility premium. They argue that the good recent performance of many smart beta factors, including low volatility, may be due to rising valuations rather than intrinsic long-term risk premia.
Irrespective of which theory is correct, there have been strong fund flows into lower volatility 60% stocks and corresponding indices have delivered 40% very strong returns over the past decade. In our view, some of this opportunity set has already been arbitraged away.
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