By Ashwin Alankar, Michael DePalma and Richard Abramson
In a recent blog, Passive Management Does Not Equal Passive Investing, we showed how passively managed portfolios actually create an active investment in which volatility isn’t benign and risk exposures can vary wildly over time. So if we could fix the problem and reduce exposure to spikes in market volatility, would a passive portfolio deliver better result?
To address this question, let’s understand how a passive investment is meant to create value in the first place. The key to successful passive investing is diversification. It’s a simple idea: spread equal risk across investments and time, so that the portfolio operates at a constant risk level and exposures. The winners should outweigh the losers.
But varying risk exposures and risk levels are the enemy of the traditional passive approach. That’s because it leads to leaps in volatility. When a portfolio’s exposures are constantly changing, diversification isn’t given a chance to work.
The Pain of Volatility
For any investor, volatility can be especially damaging because of the effects of compounding. For example, a $100 investment in a high-volatility stock that rises 50% and then falls 50% has lost $25. Yet an investment in a low-volatility stock that goes up 5% and falls 5% has only lost $0.25. This is caused by a phenomenon known as “risk drag.” Over the five largest down markets since 1926, the US market-capitalization-weighted equities index lost 50% on average and it took nearly five years to recoup the losses. This is known as the pain of risk drag. Diversification is supposed to reduce risk drag, which is the source of its value.
While these examples are extreme, they help illustrate the flaws of a traditional passively managed portfolio, in which diverse positions are not equal over time and fluctuate because of the dynamics of world markets and events. The good news is that this problem can be addressed by creating a portfolio that takes static and constant risk across industries.
Testing an Alternative Passive Approach
To test the theory, we constructed a model portfolio — a “Balanced S&P 500” index — that rebalanced each month to equalize risk exposures for each market cap–weighted S&P 500 sector. We also operated the portfolio at the average long-term risk level of the index. Then, we compared this portfolio with the S&P 500 Index. As the display shows, we found that by consistently maintaining equal risk exposures and constant overall risk, the portfolio would have returned 1.5% more per year on average than the S&P 500. And the drawdown would have been 20% lower, so an investor would have enjoyed higher returns with lower drawdown risk.
There are, of course, challenges to this approach. For example, as shown in the display, as the Internet bubble inflated, the Balanced S&P 500 trailed the S&P 500 by a significant amount. This is because at the time, the S&P 500’s volatility was very high and in these conditions, taming the turbulence restrained market gains.
Indeed, volatility isn’t always the best measure of risk because it acts to reduce not only outsized losses, but unfortunately also outsized gains. But over time, our research suggests that clamping down on volatility and maintaining diversification should prevail. Investors should always remember that winning the loser’s game — as described in the classic Charles D. Ellis book of that name — is all about losing less in down markets.
Traditional passive portfolios are susceptible to large drawdowns and unstable performance. We think that a better passive mousetrap can be built by striving for static risk across industries — and over time — to reduce risk drag and to give diversification time to deliver results.
This blog was originally published on InstitutionalInvestor.com.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Ashwin Alankar and Michael DePalma are Co-Chief Investment Officers of Tail Risk Parity Services at AllianceBernstein. Richard Abramson is Managing Director — Client Solutions at AllianceBernstein.