Low Volatility as a Fiduciary Duty

Low Volatility as a Fiduciary Duty
February 3, 2012

Mike Moody, John Lewis and the Dorsey Wright team run a superb shop, and our views overlap about 80% of the time (systematic vs. clinical, anti-forecast, RS, etc.), but I feel compelled to address a recent post on their SystematicRelativeStrength blog (SRS).

The SRS blog took issue with a quote by investment legend and individual investor advocate David Swenson, who has led Yale’s endowment fund successfully since 1985. We endorsed his statement yesterday in a post, but here it is again:

“A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

SRS was troubled by the assertion that investors are more likely to stick with a low volatility strategy, and used Dalbar’s study of investment behaviour to prove their point. Specifically, they noted that historically investors have been no more inclined to hold onto lower volatility bond funds than higher volatility stock funds. From SRS:

“I have a few issues with this. First, the data argues that low-volatility funds are not the answer. If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t.”

I find this argument disingenuous and logically flawed. For evidence, I have drawn a chart using data from the 2011 Dalbar study (see full study here):

Source: Dalbar (2011)

Note that investors are indeed no more likely to hold onto bond funds than equity funds, with the average holding period for both around 3.2 years or so. However, what the SRS article did not mention (strangely, since they have several asset allocation funds), was that the investors tended to hold asset allocation funds for a full 33% more time than either stock or bond funds on their own. Huh.

The category of Asset Allocation funds is overwhelmingly dominated by balanced funds of stocks and bonds. Investors who allocated capital to asset allocation funds explicitly outsource the asset allocation decision to the fund manager, who they expect will bias the fund toward or away from stocks or bonds as opportunity knocks.

Dorsey Wright manages a Balanced Fund (Arrow DWA Balanced Fund) with annual turnover of 59%, which implies an average holding period of 1.69 years (1/0.59). The highest ranked fund in the U.S. Balanced Fund category, the Intrepid Capital Fund, had an annual turnover of 88%, implying that the fund turns over almost its entire portfolio about once per year (every 1.14 years to be exact).

Does this high turnover mean that these fund managers are trading their portfolio on intuition or emotion? Does it demonstrate a lack of expertise or conviction in their approach? I don’t think so. Rather, the managers of these successful funds are moving capital around to take advantage of opportunities they identify, in DWA’s case through their proven relative strength system.

Turnover is not a measure of investors’ preferences; rather investors prefer the best returns for the lowest risk. Neither stocks nor bonds on their own can deliver this objective because they are much better together than either is on its own. Investors know intuitively that there are times to emphasize bonds and times to emphasize stocks. The less successful ones try to time these changes on their own, and make binary decisions to switch between them, while the successful ones leave the decision to experts who adapt portfolios incrementally over time.

Literature from the institutional space is beginning to identify the power of dynamic asset allocation (DAA). This approach advocates more frequent rebalancing based on changing expected return, volatility and correlation dynamics. This type of strategy often has higher turnover, but can be engineered for quite low volatility. Their objective is to capture a large proportion of upside returns from a diverse set of asset classes, but continuously optimized diversification protects portfolios from major losses. As a result, investors are more likely to stick with these strategies because they experience a steady return trajectory like bonds, but capture substantial equity returns as well.

Low volatility DAA strategies are also highly optimal for retirement outcomes because of the sensitivity of retirement plans to large sustained losses, especially in early years.

In summary, Swenson asserts that investment advisors with their clients’ best interests at heart would guide clients toward low volatility strategies, mostly because these strategies are much easier to stick with through thick and thin. We have also shown, counterintuitively, that low volatility strategies may provide stronger absolute returns as a result of their smoother ride. This makes them especially compelling for investors nearing or in retirement, and who wish to maximize retirement spending while sleeping well at night.