October 2009

Tools for reducing risk:

Introducing the Low Volatility
Portfolio
In our August 2009 FOCUS article on liability driven investing (LDI), we outlined how, in
the wake of the recent global liquidity crisis, many pension plans and insurers faced serious
funding-ratio deficits and were revisiting the fundamentals of how they managed risk. In
some cases, plan sponsors were shifting to an LDI strategy — making investment decisions
in the context of liability risk, and moving away from an asset-only focus.
In response to this situation, TDAM has been working to provide our clients with solutions
that fit their increasingly risk-averse reality. For institutional investors who are searching for
The LVP is constructed
tools that work within a risk-focused framework, our new Low Volatility Portfolio (LVP)
by determining the risk
may be ideal. It is an equity portfolio designed specifically for risk-focused investors, and
that each security
its primary aim is the reduction of the risk that equities bring to a portfolio.
contributes to the
portfolio (both absolute,
Spotlight on equity risk
as well as relative to its
TDAM’s LVP is an inherently conservative equity portfolio. Like the market benchmarks, it fellow stocks) and
is composed entirely of equity securities. No derivatives, shorting, or leverage are used. The optimizing the risk mix for
Canadian LVP is comprised of securities found in the S&P/TSX Index, while the global a better risk-adjusted
version is comprised of securities from the MSCI Index (excluding Canada). Both are built outcome.
from a Canadian-dollar return perspective. This simple construction is easy for committee
members to understand and makes it unlikely that the LVP will run into difficulties with
policy constraints.
However, the LVP differs from the benchmarks in a key way: whereas the benchmarks are
built on the basis of market capitalization — that is, weightings are based wholly on size,
irrespective of risk — our portfolio is fully focused on risk. It is constructed by determining
the risk that each security contributes to the portfolio (both absolute, as well as relative to its
fellow stocks) and optimizing the risk mix for a better risk-adjusted outcome.
Market cap vs. risk-adjusted weightings
With few exceptions (like the Dow Jones Industrial Average), the standard benchmarks are
created using market capitalization (or float weighting, which excludes shares with sale
restrictions) as their sole criteria. In other words, there is no effort made to adjust the
composition of the index based on risk. An index in a smaller market like Canada may
oftentimes be disproportionately weighted towards stocks in certain sectors (financials or
commodities in our case), or even tilted towards one particularly strong stock, in a way that
has a significant impact on the level of risk inherent in the index. A notable example of this
was Nortel Networks during the late 1990s tech boom. At one point Nortel was worth
nearly 1/3 of the value of the (then) TSE Index, introducing a serious level of risk for
investors in the index.
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 It is ironic, then, that many risk-
adverse investors “buy the index” for
the safety of diversification, ignoring
the risk of the index itself. Owning a
large number of securities adds little
diversification benefit if most are in
the same industry, are cyclical
stocks, or are highly correlated in
various other ways.
Recognizing the opportunity to
create a more efficient portfolio,
the LVP takes the index and uses it
as a basis for a much more risk-
averse approach. It selects from the
same securities universe as the
index, but uses risk-based criteria
to determine the inclusion,
exclusion, and optimal weighting
of the stocks in the portfolio. The
rationale behind this approach is
simple: a cap-weighted portfolio is
not optimized for risk, and
therefore there is room for a more
efficiently constructed alternative.
The reassessment of the efficiency
Exhibit A: A top-ten stock sampling comparison
The table below shows how the top ten stocks in the S&P/TSX might fare in the
LVP once their weightings are optimized for risk.
Source: TDAM and TSX Group,
Data as of June 30, 2009
of the market capitalization index is
the starting point of the LVP. Here
is how it works.
Risk modeling and
optimization
The LVP combines the research on the
inefficiency of cap-weighted indices
with quantitative techniques that use
standard deviation and covariance
analysis to determine which stocks will
deliver the optimal risk-adjusted
returns. The optimization model
selects stocks that are expected to offer
less volatile returns. While the model
predicts risk, it does not factor a
specific expected level of return into
its analysis.
The process begins with the existing
index. Historical information about
these stocks is used to create a matrix
of historical volatility. The key
inputs to the model are historical
prices, which generate the standard
deviation figures. More recent
volatility data are given greater
weights to keep the estimates current.
The model assesses both the risk of
each individual stock (idiosyncratic
risk), and the relationship between the
stocks (correlation) to determine the
optimal weight of that stock in the
LVP. Each portfolio has specific
guidelines or constraints in terms of
the total number of positions,
percentage of maximum sector
exposure, and the percentage of
maximum individual security exposure
permitted. These constraints are
factored into the model to determine
the final LVP weightings.
An ongoing active process
The creation of the portfolio is an
ongoing process. It requires regular
rebalancing as appropriate in terms
of the risk outcome and daily
monitoring. When rebalancing, the
portfolio management team only
undertakes trades that result in a
material reduction in expected
volatility. If a significant market
event occurs that is not yet reflected
in the model’s data, the portfolio
management team will adjust the
portfolio accordingly.
Again, in line with the strategy of the
LVP, this type of modification is
designed to manage risk, not to place
bets on perceived excess return
opportunities. The optimization
model and management team
function as a cohesive risk-reduction
unit, combining quantitative
technology with human judgement,
and ensuring an immediate and
effective response to relevant
changes in data and the market
environment.
One of the tradeoffs of using this
model is that continual rebalancing is
needed in order to keep the portfolio
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 holdings up-to-date with the most
current volatility data. This results in
active trading and high turnover. To
ensure that only trades that result in a
material reduction in expected
volatility are undertaken, we use a
stopping rule. This is another
constraint factored into the model,
and it helps to reduce trading costs.
Characteristics of the LVP
Because of the unique portfolio
construction process employed, the
LVP will look quite different from
the benchmark. Weightings may be
quite different, and not all securities
present in the benchmark will be
present in the LVP.
In practice, the LVP demonstrates a
bias towards so-called “value”
stocks, towards stocks that deliver a
greater dividend yield, and towards
mature non-cyclical sectors like
consumer staples, healthcare, and
utilities. It also tends to favour
smaller capitalization stocks.
Exhibit B:
TD Emerald Canadian Equity Low Volatility Portfolio back-test performance, 1990-2009
Source: TDAM and TSX Group,
January 1990 – June 2009
A divergent composition
Exhibit A shows an example of the
LVP composition compared to the
S&P/TSX Index. The sample LVP
differs significantly from the
benchmark, with the LVP holding 99
stocks in comparison to the
benchmark’s 209, and with
significantly different weightings. Note
that of the stocks shown — the top ten
stocks in market capitalization — fully
one half of them do not make it into
the LVP at all. And those that do make
the cut have a much smaller weighting.
Some of this difference is explained
by the standard deviation data: a
stock like RIM, high in terms of
market capitalization, also
demonstrates a high level of
volatility that makes it less than ideal
for the LVP. Other stocks, some with
smaller standard deviations,
nonetheless may be problematic in
terms of their correlation. Just a
glance at these top ten stocks, for
example, reveals the tilt towards
financials and commodities common
to Canadian indices. The LVP avoids
this imbalance.
This notable difference in weights
between the LVP and the index will
translate into a high level of tracking
error, and yet, as shown in Exhibit B,
the long-term performance of the
LVP remains very similar to the
benchmark — merely less volatile, as
is intended.
The results: Better risk-
adjusted returns
The LVP has been rigorously back-
tested over a long period of time and in
different volatility environments to
ensure that it delivers consistent
results: a low systemic risk coefficient
or “beta” of less than 1 (i.e. volatility
of less than the market). Exhibit B
demonstrates the results of back-
testing the Canadian LVP starting
from 1990. The reduced volatility of
the LVP is easily visible in the graph.
In the test period shown, the largest
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 Another volatility-fighter:
total monthly loss of the benchmark was -20.11%, while for the LVP it was An options overlay
-12.63%. The annualized net return for the benchmark was 7.50% and
An options overlay strategy is another tool
10.45% for the LVP. The average annual total risk was 15.57% for the
designed to dampen overall volatility in
benchmark and 10.15% for the LVP, with a Sharpe Ratio of 0.17 for the
your equity portfolio. It is, in effect, an
benchmark and 0.54 for the LVP.
insurance policy, where a portfolio buys
In the short term, in a bull market, the portfolio may underperform given and sells options to protect its downside
that its mandate is to dampen dramatic movement and, of course, the risk by selling some of its upside potential.
dampening effect works on the upside as well as the downside. Over time, TDAM’s options overlay provides your
however, the LVP is expected to deliver better risk-adjusted returns in portfolio with loss protection up to 15% by
comparison to the benchmark. In our tests, the LVP has reliably delivered a capping gains at 15%.
similar or stronger performance than the index for twenty years of data.
In other words, if the market drops 15%,
An alternate way forward your portfolio loses nothing. If it drops
The theory behind the LVP or minimum variance portfolios is not new. It 20%, your portfolio loses only 5%, and so
began as an outgrowth of academic research testing the Capital Asset on. Similarly, on the upside, if the market
Pricing Model (CAPM) and finding inefficiencies in the market gains 15%, your portfolio does likewise.
capitalization portfolio construction. The LVP theory has been tested and If the market gains 20%, however, your
put into practice in various markets around the world. However TDAM is, gain remains at 15%. The result of this
to our knowledge, the first to offer an LVP portfolio in Canada, strategy is the reduction of portfolio
constructed in Canadian dollars. volatility and overall risk levels.

Because of this novelty, there is a need for education on how an LVP differs The pricing of options is a function of
from the norm. Considering an investment in an LVP requires an acceptance volatility, so options are very expensive in
that the goal is reducing risk and that, depending on the circumstances, this today’s volatile market. However, TDAM’s
may mean underperformance in comparison to the benchmark. It is also options overlay can be implemented in a
necessary to understand how very different the composition of the LVP cost-effective way: The options sold cover
may be from the benchmark. If an extreme divergence is not acceptable, the costs of the options purchased.
than the LVP will not be a good fit. The LVP’s sizeable tracking error, Depending on your situation, an options
rather than being a concern, should be viewed as irrelevant, given that it is overlay may be a useful tool for your
not designed to track the benchmark, but to use it as a starting point for the portfolio. Currently the TDAM option
creation of a more risk-averse portfolio. overlay strategy is only available in
Given the market’s recent erratic behaviour, many institutional investors segregated solutions. For more
may be reconsidering their risk appetites, and reviewing, in particular, the information please contact your
risk levels that equities contribute to their portfolios. An LVP is not a Relationship Manager or speak to a
panacea for all that ails the market, but it is one proven way to maintain an member of our team of specialists at:
equity component in your portfolio while enjoying the benefits of less Telephone:1-888-834-6339
volatility and better risk-adjusted returns.♦ E-mail: inst.info@tdam.com
Jean Masson, Ph.D., is Managing Director at TD Asset Management Inc. in Montreal.

TD Asset Management Inc. (TDAM) is a wholly-owned subsidiary of The Toronto-Dominion Bank (TD Bank).
The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in
providing it does TDAM or the TD Bank assume any responsibility or liability. TDAM or the TD Bank is not liable for any errors or omissions in the
information or for any loss or damage suffered. Where such statements are based in whole or in part on information provided by third parties, they are
not guaranteed to be accurate or complete. The information does not provide individual financial, legal, tax or investment advice and is for information
purposes only. Particular investment or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.
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