Managed Volatility: Exploiting a Risk-reward Anomaly in the Equity Markets

January 16, 2017

Lower volatility doesn't have to mean lower returns

We put our focus directly on risk.

Decades ago, there existed a common assumption that risky stocks should outperform less risky stocks. According to modern portfolio theory, this makes sense, right? Well, not exactly.

Back in the 50s and 60s, one of the core ideas was that the expected return on an investment should be commensurate with its risk, with risk typically measured in terms of volatility. This idea was intuitive and straightforward; investors should demand a greater return for holding an asset that has a more volatile (less predictable) pattern of returns.

But here's the rub: Analysis of real-world market data found that, as a group, investors appeared to systematically overpay for higher-volatility securities and underpay for lower-volatility ones. Said another way, returns on high-volatility stocks were significantly lower, and returns on low-volatility stocks were higher, than prevailing finance theories predicted. This was a significant and unexpected finding — an anomaly, in financial parlance — that has been confirmed by subsequent studies using data from other time periods and other markets.

The rather compelling upshot was that an investor might be able to earn better-than-expected returns for a given level of risk.

The potential investment opportunity became apparent — by investing in a portfolio of lower-volatility stocks and avoiding higher-volatility ones, a portfolio manager should be able to achieve a better balance between risk and return

Our innovative, pioneering approach

The evidence supported that a portfolio made up of low-volatility stocks should achieve a better risk-adjusted return than a portfolio made up of high-volatility stocks.  That's why we seized on the opportunity and launched our US Managed Volatility Fund -- the first of its kind, we believe -- in October, 2004.

    We launched our US Managed Volatility Fund -- the first of its kind, we believe -- in October, 2004.

    Our embrace of a managed-volatility approach required a change of mindset:

    1. A focus directly on risk
    2. A sector- and industry-agnostic allocation approach

    Traditional investment management focuses on a portfolio’s expected return relative to a benchmark; at the same time, it tries to limit the portfolio’s divergence from that benchmark. By doing so, a manager accepts that their portfolio will probably experience benchmark-like volatility. In contrast, when developing our managed volatility approach, we put our focus directly on risk. Each of our managed-volatility offerings has a volatility-reduction target compared to its benchmark.

    We also determined that, to achieve this objective, our managed-volatility strategies should be sector and industry agnostic. As a result, our sector allocations tend to differ significantly from the broader market. Less-volatile sectors will tend to be significantly overweighted, and more volatile ones are often heavily underweighted.

    Over short periods, our sector-agnostic philosophy can lead to significant return disparities between a managed volatility portfolio and its benchmark. However, over long periods of time, we expect returns to be similar to those of the broader stock market (of course, there is no guarantee this will be the case). It’s also important to note that shifts in sector and industry behavior do occur. When we or one of our managers see this happening, we will adjust our portfolio accordingly. Our process is very empirical and data-driven; we are not wed or averse to certain sectors simply because they behaved a certain way in the past.

    The managed volatility revolution

    In 2006, we expanded our suite of managed-volatility solutions by launching our Global Managed Volatility Fund. In 2007, we launched our Tax-Managed Managed Volatility Fund for tax-sensitive investors seeking lower equity volatility. We have also introduced our managed-volatility strategies to markets outside of the U.S.

    The rest of our industry was, for the most part, slow to adopt these strategies; that is, until the aftermath of the 2008 financial crisis and market meltdown. Since then, interest in low-volatility equity portfolios has taken off.

    In a very real sense, we helped to pioneer the managed-volatility revolution.

    It’s gratifying to see widespread adoption of an investment strategy that we helped pioneer over a decade ago. However, we are not content to rest on our laurels. Thanks to our innovative and pioneering spirit, we have continued to affirm our commitment to this space by adjusting our approach to changing market dynamics. Given the robustness of our approach, we believe we are well-positioned to help investors implement such a strategy, either on a standalone basis, or as part of a diversified portfolio.

    Legal Note

    This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.
    For those SEI Funds which employ the `manager of managers' structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SIMC is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCO). SIMC and SIDCO are wholly owned subsidiaries of SEI Investments Company.
    There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met.

    To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds' full and summary prospectuses, which can be obtained by calling 1-800-DIAL-SEI. Read them carefully before investing.