This is a concept that we fundamentally disagree with. Why?
Take turkey farmers for example. A turkey is born and enjoys an extended period of very low volatility growth. From a narrow perspective as it fattens, the turkey looks increasingly like a winning bet. However if you widen the perspective it may not be so lucrative; the growing threat of Christmas is looming. The Turkey’s low volatility growth belies an obvious risk, a principle we often observe in financial markets too.
The charts below demonstrate this, showing the live weight of the turkey and the performance of a fund dedicated to shorting the VIX volatility index that fell sharply overnight in February 2018 when the volatility index spiked. In both cases a rare but predictable event arrives bringing extreme volatility.
Our concern is that the asset management industry’s over reliance on volatility as a measure of risk is driving some dangerous distortions, including chunky allocations to increasingly overvalued low volatility assets such as corporate bonds, defensive equities and structured products.
To make matters worse this error is frequently compounded by the belief that by packing a portfolio full of different low volatility components we can manufacture a product that suits a low risk client; in essence the more turkeys the better. This theory can only work if we assume that the individual components of the portfolio are not all vulnerable to the same thing. Which is why the second key assumption becomes important.