By Richard Yasenchak, CFA, CFP®, Senior Managing Director, Head of Client Portfolio Management
September 9, 2025
Topic: Diversification, Volatility, Rebalancing
Key Takeaways
- Portfolio returns come from more than just picking the right stocks.
- Volatility effects—how stocks move relative to each other—are a potential return source.
- Stochastic Portfolio Theory explains how this return component works and how it differs from stock effects.
Core equity investing often centers on one question: Which stocks will perform best? But there’s more to portfolio growth than stock selection alone.
While stock effects—the returns driven by individual company fundamentals—are important, they are only part of the equation. The other part is less talked about but just as real: volatility effects. This overlooked return source emerges from how stocks move in relation to one another and can be systematically captured through portfolio construction.
More Than Stock Picking
This foundational insight is often overlooked by traditional managers, but it lies at the core of Intech’s investment philosophy. Formalized in Stochastic Portfolio Theory (SPT), developed by Intech’s founder, Dr. E. Robert Fernholz, the framework decomposes portfolio growth into two distinct sources:
- Stock Effects – Gains or losses that come from changes in a company’s intrinsic value.
- Volatility Effects – Incremental returns generated by the differences in how individual stocks’ prices move over time.
This decomposition is not just theoretical. It provides a precise mathematical framework that helps us quantify and pursue structural sources of return that many strategies ignore. But the power of the approach lies not only in recognizing both components—it lies in integrating them within a unified, systematic process.
The figure below illustrates this decomposition visually, showing how a portfolio’s compound return can be broken into the weighted average of the individual stocks' compound returns (stock effects) and an interaction term that captures the structural contribution of volatility and correlation (volatility effects).
Under Stochastic Portfolio Theory (SPT), developed by Intech founder Dr. E. Robert Fernholz, volatility effects are not random noise—they are a quantifiable part of portfolio growth.
The process works like this:
- Stock prices move differently based on their fundamentals, market sentiment, and other factors.
- These differences create changes in portfolio weights.
- By systematically rebalancing—selling a portion of stocks that have risen relative to others and adding to those that have fallen—the portfolio can capture a rebalancing premium.
This premium does not depend on predicting the direction of the market or timing specific factors. Instead, it relies on relative stock volatility.
Why Volatility Effects Are Overlooked
Despite being measurable, volatility effects rarely take center stage in investment conversations. There are several reasons:
- Narrative bias – Stock-picking stories are more compelling and easier to market.
- Attribution blind spots – Traditional performance reports rarely isolate volatility effects.
- Implementation challenges – Capturing these effects requires consistent rebalancing, which is not easily overlaid on a traditional fundamental process.
As a result, many portfolios either miss the opportunity entirely or capture it inconsistently.
A Structural Source of Return
A feature of volatility effects is that they are structural, not cyclical. While individual factors like value or momentum can go in and out of favor, volatility is a constant feature of markets. This makes it a potential complement to stock selection, rather than a replacement.
When managed well, incorporating volatility effects can:
- Help maintain diversification in concentrated markets.
- Reduce reliance on a small set of outperforming stocks.
- Provide uncorrelated return potential.
Maintaining Alignment with the Benchmark
One of the most important considerations for fiduciary advisors, CIOs, and platform gatekeepers is tracking error. Large deviations from a benchmark can complicate model portfolio management and client communication.
Strategies that systematically capture volatility effects can be designed to keep tracking error low, maintaining compatibility with established allocation models. This is critical for integrating them as core holdings without causing unintended style drift.
"Core equity can capture more of the market’s potential by paying attention to how stocks interact—not just which ones you own."
Volatility and Diversification
In a cap-weighted index dominated by a few large companies, diversification can erode over time. Volatility effects provide a mechanism to refresh that diversification without making wholesale shifts in holdings. The process is data-driven and scalable, using volatility and correlation measures to determine weight adjustments.
This doesn’t require excluding large companies. Instead, it ensures they don’t dominate portfolio dynamics to the point where diversification breaks down.
The Takeaway
Volatility effects are often misunderstood as a risk to be minimized. In reality, we believe volatility’s ever-present nature in markets offers investors a potential return source when harnessed systematically. By integrating both effects into a disciplined, systematic process, portfolios can preserve the benefits of benchmark alignment while improving their diversification profile.
If you’re ready to see how volatility effects can fit into your core equity allocation, download the full paper to learn how these concepts are applied in Intech ETFs.
Important Disclosure
The views expressed herein are those of the author as of the date of publication and do not necessarily reflect the views of Intech or its affiliates. This material is for informational purposes only and does not constitute investment advice or an offer to buy or sell any security.
All investments involve risk, including the possible loss of principal. There is no guarantee that any product or strategy will meet its investment objectives. Equity markets may be volatile, and the value of a given investment can fluctuate due to general market conditions, economic events, and changes in individual securities.
This content is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any security or investment services in any jurisdiction. This content does not contain sufficient information to support an investment decision. Potential investors should consider their own circumstances and assess the legal, regulatory and tax implications before making an investment decision. All investments are subject to risk, including the possible loss of principal. Past performance does not guarantee future results.
This content is for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. This content is also not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any security or investment services in any jurisdiction. This content does not contain sufficient information to support an investment decision. Potential investors should consider their own circumstances and assess the legal, regulatory and tax implications before making an investment decision. All investments are subject to risk, including the possible loss of principal. Past performance does not guarantee future results.
