Less Volatile Portfolios: Strength through Simplicity

Abstract

One prominent trend in equity indexing in recent years has been indexes that target a lower volatility than a capitalization-weighted benchmark. To read the ground rule document of indexes using optimization procedures, one would think that it requires fine detailed predictions of return distributions and finely tuned constraints. In truth, the same outcome can be achieved with a far simpler set of rules, as the authors show in this article. The value of simplifying portfolio construction is twofold: robustness and stability. Robustness means lower sensitivity of the portfolio to input assumptions, decreasing the likelihood of changes in performance out of sample. Stability of solutions through time means that the portfolio can be allowed to run with fewer constraints, ensuring that the desired outcome (in this case lower volatility) can still be achieved without undue turnover in the portfolio. The authors demonstrate a simple method that can be used to build more robust volatility-lowering portfolios.