In response to the growing interest in low volatility investing, VelocityShares, a specialist in designing exchange-traded products and tail-risk strategies for institutional investors, has published “Alternative Index Weighting and the Impact on Portfolio Risk” to help investors assess the benefits and pitfalls of alternative weighting strategies.
The paper reveals that investors who are trying to overweight low volatility stocks face large variation in the embedded risk among popular approaches.
“Many investors do not realise that so called ‘low volatility’ weighting only leads to a low volatility portfolio under an unrealistic set of assumptions,” says Scott Weiner, head of quantitative strategy at VelocityShares. “Many alternative equity weighting schemes intend to capture the low volatility anomaly, but not all approaches deliver the desired results.”
It is well known that market capitalisation weighted portfolios are not themselves mean-variance efficient, and there has been a growing interest in trying to capture the low volatility anomaly. VelocityShares’ new paper finds that popular alternatives, such as equal and low volatility weighted approaches, have high idiosyncratic risk and are themselves only mean-variance efficient under unreasonable assumptions.
The paper concludes that equal risk weighted and minimum variance approaches produce lower volatility portfolios. The equal risk weighted approach does so with less idiosyncratic risk. Additionally, the paper reviews the assumptions behind the many lower volatility approaches that have been become popular in the market.
