Benchmarking low-volatilty strategies
July 4, 2011
Low volatility investing and performance measurement — my favorite topic scheme — how could I resist?
The paper
The paper is “Benchmarking Low-Volatility Strategies” by David Blitz and Pim van Vliet.
The problem
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
Their solution
Given the problems with a low-volatility index, they essentially suggest just giving up and benchmarking against the capitalization-weighted index.
My take
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?
Something else?
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.
Epilogue
Red hair and black leather my favourite colour scheme
from “1952 Vincent Black Lightning” by Richard Thompson
Andreas,
Well, okay. If we did have risk benchmarks, what would we be gaining?
We would have a yardstick to assess the portfolio. The focus would be on risk characteristics (level, contributions, dynamics), not return.
Andreas,
I’m back to what I said in the post: What’s the question?
And once we have an answer, how does that affect our behavior?
That is, do you have any specific scenarios in which a risk benchmark would help a fund manager?
I remeber a case in which a low risk manager did not perform and subsequently played “double-or-nothing”, i.e. massively increased risk. The discussion was very akward initially because it focused on performance; risk-benchmarks made people remember again the original purpose of the product.
Another common case are “low risk” portfolios that are managed relative to a constant risk target (for example, VaR). Managers of such portfolios are very often (typically in bull markets) confronted with complaints that they “underperform” relative to some benchmark which is not subject to risk restrictions. Risk-based benchmarks are essential for such managers. On the other hand, clients also need risk-based benchmarks in order to confront managers who use risk limits as an excuse for their underperformance: “I underperformed so much because I was forced to reduce risk”. Random portfolios give very interesting answers in the last situation: they can be used to demonstrate whether a risk limit was binding or not.
Andreas,
Thanks. I think random portfolios are a good tool for all of your situations: they give you a distribution rather than a single number, and they can be specialized for the question at hand.