Does the Low Volatility Alpha Fund Exist?

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While many investors might pick a low-volatility strategy for its risk-controlling attributes, these products are also promoted for their ability to produce market-beating returns.

Modern portfolio theory would suggest otherwise, since higher returns are assumed to be a function of greater risk. Finance theory uses volatility as a proxy for risk.

Modern portfolio theory quantifies volatility risk with beta coefficients, alpha.

A fund or portfolio with a beta value of less than 1 is essentially less volatile than the market, while a beta value of more than 1 means volatility will be more exaggerated than the market’s movements.

A low-volatility fund offers a tilt towards funds with low beta coefficients, since they tend to generate more consistent returns.

Basic finance theory, in which markets are assumed to be efficient, implies that low-risk strategies will not generate market-beating returns since low beta values should result in low risk premiums.

For accepting additional risk, investors demand a risk premium (or higher return) as compensation.

Using the capital asset pricing model, the risk premium is calculated as:

β(RM – RF)


β = the beta coefficient of the fund (or volatility relative to market volatility)

RM = return from the market (which can be represented by benchmark indices like the S&P 500)

RF = the risk-free rate of return (often represented by treasury yields)

Possible explanations for alpha returns

Low-beta funds that do generate alpha returns would then appear to be exceptions to the rule. But some argue that in times of market uncertainty and high volatility, many investors seek stability and target low-volatility investments. This provides traction for these stocks and buoys returns.

Additionally, the outperformance of low-beta equity strategies could support some investors’ view that modern portfolio theory is based in inaccurate assumptions.

Though widely adopted and recognized as a tool for investors, a number of market commentators and investors believe the link between volatility and risk should be abandoned, partly because markets are not efficient and do not price assets appropriately.

Important to note is that many studies measure superior returns on a risk-adjusted basis, where an investment’s risk metrics are factored in to overall returns. For example, consider an equity portfolio with a beta value of 0.5. This implies that its volatility relative to the market’s is low. If the portfolio delivers the same total return as the S&P 500 Index (the equity market benchmark), its returns would be considered superior on a risk-adjusted basis.

Low-volatility products

On the back of greater demand for these and other factor-based products, most major index providers now offer low-volatility smart beta funds. Among the most popular is the iShares Edge MSCI Min Vol USA fund, which has grown significantly thanks to strong demand. The Vanguard Global Minimum Volatility Fund Investor Shares is another example.

Smart beta portfolios, sometimes known as custom indices, are built using alternative index-construction techniques. Their performance is measured against market benchmarks.

By targeting underlying fund attributes – sometimes market abnormalities which result from inefficient markets – smart beta funds can target alpha returns or aid risk management efforts.

While some low-volatility smart beta funds may be concentrated on single asset classes or markets, others aim for diversification by including low-volatility investments across different asset classes, sectors and geographies. This helps to reduce the correlation of index constituents.

Proponents of low-volatility investing argue that these strategies protect against downside risks while still capturing a fair amount of upside gains when markets rise. This is because when markets decline, investors become more wary of risk, while in growth markets, investors are more indifferent to risk. As a result, low-beta funds tend to at least match, if not beat (denoted by alpha), the market over the long term.

Low-volatility portfolios which include overvalued stocks or which lack diversification would likely be more risky over the long term than those which also favour undervalued stocks and diversification.

Meanwhile, some critics of the strategy say bonds and cash are far more reliable volatility-control mechanisms than low-volatility equity investments.

Volatility is one of many alternative beta sources used by quantitative-driven fund managers and investors in their pursuit of alpha returns and risk management. Quant strategies can be implemented through smart beta, risk premia or hedge fund replication strategies, among others. To some analysts, the outperformance of certain factors supports the theory that volatility should not represent risk.

Smart beta strategies employ active tilts on passive fund management.