From the early 1960s to today, low volatility equities have delivered very low monthly downside capture in the U.S. with substantially higher upside capture. A similar pattern can also be observed in broader equity markets since the advent of popular global benchmarks.

But disappointing 2020 low volatility performance calls the reliability of this upside/downside capture asymmetry into question over shorter investment periods. Is there a way to improve the predictability of low volatility over shorter periods?

The Quantitative Equity Team at TD Asset Management Inc. (TDAM) recently published an insightful, long-form paper, The Alpha Risk of Low Volatility Investing, which answers this question.

The answer to this quandary starts with having a better understanding of the upside/downside asymmetry. It would be easy to incorrectly assume that low volatility stocks are simply more impacted by rising markets than by falling markets. In fact, the opposite can be true over sustained periods of time.

Instead, the answer is that a substantial part of low volatility returns is not driven by monthly market fluctuations at all. For example, nearly half of U.S. low volatility returns from 1963 are independent of market returns. This independent return, often termed risk-adjusted alpha, causes the capture asymmetry by both boosting upside capture and reducing downside capture.

Improved predictability of outcomes therefore depends on stabilizing returns that are independent of the market (risk-adjusted alpha). This is an important area of research for The Quantitative Equity Team at TDAM. It requires careful consideration of the trade-offs between maintaining a high risk-adjusted alpha and improving its stability.

We cannot, for example, let 2020 markets tempt us to naively mix in new style factors or to move our portfolios closer to the benchmark. Our research shows this to be a mistake that would likely negatively impact risk reduction and/or returns.

Instead, we continue to develop ways to improve the predictability of low volatility investing where it is possible and to encourage investors to avoid seeking out an unrealistic secret recipe that would deliver sustained alpha in every possible market scenario.

Because the truth is that there is no such a thing as alpha which is completely risk-free and there never will be.

For more details, read the full paper here.