The paper is “Benchmarking Low-Volatility Strategies” by David Blitz and Pim van Vliet.
They claim that using a low-volatility index as a benchmark for a low-volatility strategy is not a good idea because:
- All low-volatility indices are essentially just arbitrary low-volatility strategies
- Some low-volatility indices constrain turnover and hence are path-dependent
- Many indices are not very transparent in their assumptions
- A global index can be suitable for at most one home currency
Given the problems with a low-volatility index, they essentially suggest just giving up and benchmarking against the capitalization-weighted index.
I agree with them about the problems of benchmarking with a low-volatility index.
They aren’t very explicit about what it would mean to benchmark against the cap-weighted index. They talk about using the Sharpe ratio or Jensen’s alpha, but don’t say what would be done with those statistics.
Whatever is done, I doubt it’s a good idea. Using a benchmark that fits the strategy is troublesome enough. Here we are talking about using a benchmark that is systematically different than the strategy.
I think it would actually be dangerous because it would give the wrong signal. During a boom the cap-weighted index would outperform the low-volatility strategy. That would encourage people to switch out of low-volatility at precisely the wrong time.
The first question to ask, I think, is: “What’s the question?”
Do we want to know how our fund is performing relative to other low-volatility possibilities?
Do we want to know how our fund is performing given the path-dependence due to our turnover constraint?
Do we want to know how low-volatility is performing relative to market-like strategies?
The paper is not very clear on the question or questions being asked. My suspicion is that random portfolios will probably have better answers than a benchmark for whatever questions there are.
Red hair and black leather my favourite colour scheme
from “1952 Vincent Black Lightning” by Richard Thompson