An example of Quantitative Strategy: The Low Volatility approach

Low volatility indices and, more broadly, products based on quantitative strategies aiming to select only low-volatility stocks, have met with growing success with the financial community and investors. However, most of these indices have major drawbacks that cannot always be addressed with additional constraints.

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A new look at the low volatility approach

Low volatility indices and, more broadly, products based on quantitative strategies aiming to select only low-volatility stocks, have met with growing success with the financial community and investors. However, most of these indices have major drawbacks that cannot always be addressed with additional constraints. THEAM offers an innovative approach that improves the operating efficiency and transparency of these strategies, which now better fit to individual investors’ needs. This is a second-generation low volatility offering that forms one part of BNP Paribas’s broader group of systematic solutions.

The empirical evidence is increasingly hard to deny. The least volatile stocks achieve, on average, returns above the most volatile ones. Low volatility indices have outperformed traditional indices by 2% to 5% annually over the past 15 years. Even in 2011, they outperformed by 11%[1] . This is one more reason for their popularity. But do all these strategies use a reliable methodology?

The literature

Low volatility indices and portfolios are based on a discovery made in 1969 by two Americans, Robert Haugen and James Hines – that low volatility equities yielded higher returns than predicted by modern portfolio theory. In other words, contrary to the general findings of the capital asset pricing model[2](CAPM), portfolios constructed with an objective of minimising variance have a higher Sharpe ratio than diversified ones based on the market cap portfolio. This "low volatility anomaly" has been observed empirically over almost all periods since 1926 and in all markets, not just equity markets.

Behavioural finance

THEAM, specialist in Index, Active systematic and Alternative portfolio management

THEAM offers investment solutions across a broad spectrum of underlying assets (equities, bonds, commodities, volatility, currencies...) through an extensive range of investment styles, from pure Beta to Alpha.

It may be due to concepts developed by specialists in behavioural finance, who consider, among other things, that investors have a natural tendency to focus on more “glamorous" stocks, i.e. those whose prospects for success seem the most obvious and that do best during market rallies. However, when things don’t go well – which often happens– they expose themselves to the bursting of speculative bubbles that they themselves have generated. In contrast, by selecting stocks that are not in the headlines of the financial press and whose prices track newsflow less, i.e. in practice, the least volatile stocks, the risk of overshooting gives way to returns that may be less "exceptional" but are steadier, particularly as they are less erratic.

Relevant but imperfect strategies

The problem is that low volatility portfolios and indices are not easy to construct. To minimise the variance of the portfolio or to maximise its diversification, extensive use must be made of equities and sectors with little exposure to market risk (i.e. low-beta). In practice this generates several methodological faults:
-A very high concentration in a few stocks and sectors, which is contrary to the objective of diversification
-Heavy exposure to model risk, which leads to very high portfolio turnover, or
-High tracking error (over 10%), which is bad news in the event of an underlying market rally.

Additional constraints

Several index providers and managers have tried to mitigate these drawbacks by adding more constraints to their construction model. But such constraints – which investors don’t necessary want – move them away from the initial objective or, in practice, lead to active optimisation strategies which do not fully exploit the low volatility anomaly potential.

THEAM’s contribution to the methodological debate

Fundamental research within the BNP Paribas group[3] has demonstrated that the "low volatility anomaly" can be found within each equity sector. This discovery is key, as it can be used to construct portfolios without sector biases that carry a perfectly acceptable level of tracking error (less than 6%), and a level of risk that can be adjusted to investors’ individual needs. THEAM has therefore developed a proprietary low volatility strategy consisting of selecting the least volatile stocks within each sector – thus sidestepping sector bias – and focusing on controlling portfolio tracking error without seeking to minimise the portfolio’s absolute volatility.

Simple and transparent to put into action

This systematic strategy is used by one fund of the BNP Paribas Equity Low Volatility range. This proprietary methodology is also tailored through dedicated mandates and can be set to any parameters, for example, “Pure Low Vol" portfolios for those investors who tracking error is no longer regarded as a constraint. This approach retains the advantages of low volatility strategies while maximising the expected returns.

These second-generation low volatility strategies pioneered by THEAM also offer transparency and simplicity. This contributes to raise the equity exposure of investors and their portfolio’s alpha with no change to their risk budget. They aim also to ensure the long-term outperformance of traditional indices with far less stress[4].

“Quant” management: the THEAM approach

THEAM is a fervent advocate of the quantitative approach. Its values are perfectly in tune with its core components: innovation, solidity, flexibility and simplicity. That said we do not believe this form of management can be elevated to the status of a fully-fledged asset class. In reality, any quantitative strategy makes active management choices. This explains why two apparently similar approaches can have substantially different results. Indeed, each of these approaches, neither of which is infallible, can be criticised for their potential methodological or practical drawbacks. Our position is therefore resolutely pragmatic: THEAM is both “monotheistic”, insofar as the quantitative management approaches that it proposes are exclusively quantitative, and “agnostic”, since we refuse to favour one strategy over another. Of course, this does not prevent us from being able to replicate virtually all the existing approaches, or propose proprietary models: all while advising the investor on the solution that we deem to be the most appropriate. This illustrates THEAM’s professionalism and ability to listen to its clients while adhering to the first rule in quantitative management: transparency.

Etienne Vincent December 2012

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[1] Comparison between global equity indices. Past performances are not a reliable indicator of future performances.

[2] “CAPM”, a model developed by Sharpe, Lintner and Mossin.

[3] Raul Leote de Carvalho, Xiao Lu, Pierre Moulin, “Demystifying Equity Risk–Based Strategies: A Simple Alpha plus Beta Description”. The Journal of Portfolio Management (2012)

[4] There is no guarantee that the performance objective will be achieved




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