How Low Volatility and Low Carbon Are at Odds

Topics: ,

Published on March 16, 2022

| 7 min read

Jim McHugh, Senior Managing Director, Business Development


The scientific consensus is clear: climate change is here. And so is demand from investors seeking to help through lessening their carbon exposures.

An asset manager’s primary objective is still, in most cases, to help you address investment challenges, not climate challenges.While that mission may not feel as existential as global climate change, it’s still necessary for the continued solvency of institutional assets. Unfortunately, some important investment solutions of our day, such as defensive, low volatility equity strategies, may appear objectionable to climate-minded investors.

Two imperatives of our day – decarbonizing and de-risking – appear to be on a collision course. Can you reconcile these objectives? What are the trade-offs?

Decarbonization Imperative

The climate change urgency intensifies each year, with rising greenhouse gas emissions contributing to the earth’s higher average surface temperature. We recorded one of the warmest years on record in 2020 – more than 1.2° Celsius (2° Fahrenheit) higher than in 1880 (see chart below).1

2020 Tied for Warmest Year on Record

Paleoclimatology tells us that the earth’s temperature has been relatively stable, but since the dawn of industrialization, the atmospheric concentration of greenhouse gases like carbon dioxide has been rising as we burn fossil fuels such as coal, oil, and natural gas.2 These pollutants absorb sunlight and solar radiation that would typically bounce off the earth and into space, trapping the heat and warming the planet.

If we continue to see an unabated rise in greenhouse emissions, extreme weather events and rising sea levels will persist, which have had and will continue to have widespread economic consequences.

De-risking Imperative

With bond yields at all-time lows and allocations to less-liquid alternatives already high, equities’ role in helping fund and pay future liabilities, or grow participant savings balances, is increasingly crucial. Unfortunately, unprecedented uncertainty at today’s lofty market levels makes it increasingly difficult for investors to stay the course with equity-dominated portfolios.

Rather than reducing equity allocations, some investors are seizing the opportunity to de-risk them. By replacing part of your core equity holding with a defensive, low volatility strategy, you have the potential to reduce overall portfolio volatility and mitigate drawdowns while at the same time preserving long-term return expectations and portfolio liquidity.

Derivatives’ Drawbacks

If you assume traditional low volatility equity strategies have to be high carbon portfolios, why not instead turn to derivatives as a means of defensive equity investing?

Derivative strategies, such as purchasing a put option, a put-spread, or a zero-cost collar, are akin to buying fire insurance for your house. The policy may be replete with caveats and generally doesn’t pay off until your home has burned to the ground. Instead, low volatility strategies help prevent your house from burning down in the first place – they act more like fire-retardant materials, attempting to add a layer of resiliency against a potential fire. They should be included as foundational elements when constructing an equity allocation.

What’s more, derivative approaches have performance costs that can rise rapidly in proportion to market volatility, timing precision, and willingness to roll the strategy forward. In contrast, low volatility strategies may lag the general market in some periods, but over the long-term have historically offered market-like returns. They also have predictable, asset-based fees that are typically lower than most traditional active-risk strategies.

The illustrations below make a simple, cyclical case for low volatility investing. Low volatility equities have historically offered market-like returns with a quarter less volatility than a cap-weighted benchmark, allowing for better compounding over time. But the recent market environment has led to record under-performance for low volatility investing. That makes allocations to defensive equity especially compelling today.

Low Volatility vs Cap-Weighted Returns_USHigh Carbon, Low Volatility Stocks

Low carbon and low volatility investing are seemingly incompatible visions, especially if you tie the benefits of low volatility investing to holding low volatility stocks. Through that lens, low volatility investing might produce a portfolio of very high carbon emitters, underscored by a significant overweight to the utilities sector.

S&P helps illustrate this perceived problem, since they employ a stock-driven approach to creating the S&P 500 Low Volatility Index. The Index selects the least volatile stocks and weights them in inverse proportion to that same metric. Consequently, relative to the S&P 500 Index, the S&P 500 Low Volatility Index has a 17% overweight to utilities – the largest overweight of any sector, in the sector with the highest relative carbon intensity. At the same time, it significantly underweights sectors with low relative carbon intensity (see below).

Stock-Driven Low Volatility Approach Overweights High Carbon Emitters

Make Low Volatility and Low Carbon Investing Work Together

The apparent positioning of this heuristic-based low volatility index may see to be in direct conflict with low carbon. It’s understandable if this seems par for the course; given the long bull market, many investors haven’t seriously examined low volatility investing lately. But there is a better way. To see how a different approach to low volatility makes it possible to surmount this obstacle, contact us here.

1. 2020 Tied for Warmest Year on Record, NASA Analysis Shows. (2021). Retrieved 14 October 2021, from

2. USGCRP, 2017: Climate Science Special Report: Fourth National Climate Assessment, Volume I [Wuebbles, D.J., D.W. Fahey, K.A. Hibbard, D.J. Dokken, B.C. Stewart, and T.K. Maycock (eds.)]. U.S. Global Change Research Program, Washington, DC, USA, 470 pp, doi: 10.7930/J0J964J6

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value.

An index is unmanaged, is not available for direct investment, and does not reflect the deduction of management fees or other expenses. There is a risk/reward tradeoff that comes with investing in defensive equity strategies. These risk strategies are likely to underperform the index during periods of strong up markets and may not achieve the desired level of protection in down markets.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein, if shown. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by MSCI.

S&P 500 Dow Jones Indices LLC and/or its affiliates make no express or implied warranties or representations and shall have no liability whatsoever with respect to any S&P data contained herein. The S&P data has been licensed for use by Intech and may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices, please visit