I found this white paper by Acuitas Investments this week, and I think it has some valuable insights in it.
In the wake of the market volatility over the last six years, many investors have become more risk averse in the management of their equity portfolios. This is despite the fact that many defined benefit plans are underfunded and it has been difficult to replace equities with other return-generating assets in order to achieve return targets. In addition to the greater risk aversion in response to volatile markets, other factors contributing to declining equity risk budgets include a push toward liability-driven investing and efforts to immunize maturing portfolios.
Regardless of the cause, a widespread trend has emerged toward lowering the amount of equity risk in portfolios, with a corresponding drive to identify more efficient strategies that can improve the risk/reward characteristics within the equity portfolios. This effort has led investors to embrace many “smart beta” strategies. Unfortunately, the move toward lowering risk in what has traditionally been the dominant return-seeking portion of portfolios often means sacrificing expected long-term returns. This leaves investors at risk of not being able to meet their return targets. Acuitas believes a lower risk budget does not preclude investors from taking advantage of inefficiencies in the equity markets to improve returns. Instead, it increases the importance of getting as much return as possible on a limited risk budget. Using investments in less efficient areas of the equity markets like US Microcap and Non-US Small Cap alongside smart beta strategies is a way to improve returns while lowering volatility.
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