Extracting Value from Volatility
It is accepted that in order to generate returns in excess of the risk-free rate, an investment strategy must assume some risk. Generally, the greater the risk, the greater the opportunity for returns. Investors trying to outperform the risk-free rate, or more commonly a benchmark index (such as the S&P 500®), have a range of “risk factors” which they can feature in an investment portfolio.
Some common risk factors in the equity space include Value, Growth, Quality, and Momentum. As an example, an investor that is trying to capture the Value risk premium can overweight those stocks that exhibit stronger Value characteristics, and underweight those stocks that exhibit weaker Value characteristics.
Another risk factor that is becoming increasingly popular is Volatility. We refer to this as the Volatility Risk Premium. In recent years, it has become common for investors to tilt portfolios towards lower volatility stocks in search of outperformance. But volatility is more powerful than a screening tool for stocks, and can be accessed more precisely by investors to add uncorrelated, incremental returns to an investment portfolio.
Strategies that access the Volatility Risk Premium have become a compelling tool for investors.