Low Volatility Funds Offer Interesting Risk/Reward
Low Volatility Equity Funds Some low volatility stock funds offer equity market exposure, with less risk.
Historically, the returns of lower volatility stocks have often been about the same as the overall stock market, and the risk has been substantially less than the market.
We think funds that invest only in the lowest risk stocks are interesting, especially for more conservative investors.
Conservative investors today are likely to have large allocations to bonds, which we think are likely to produce disappointing returns over the next five years due to very low current interest rates.
These new low volatility stock funds may provide a good alternative to part of a conservative investor's bond portfolio.
They can also offer some downside protection for all investors relative to their equity portfolios.
After the wild ride in the stock market we have recently experienced, many investors are looking for less volatility in their portfolios.
What are low-volatility funds? There are several funds that invest only in lower volatility stocks.
The largest ($4.
6 billion in assets) is the Powershares S&P 500 Low Volatility Portfolio (SPLV).
This fund invests in the least volatile 100 stocks out of the 500 stocks in the Standard and Poor's 500 stock index.
Volatility is measured by the standard deviation of returns over the past year.
The stocks that make the "least volatile" list are generally large, blue-chip companies with strong balance sheets in stable (non-cyclical) industries.
We estimate the low volatility funds are about 25%+ less risky than the overall U.
S.
stock market.
The observation that low volatility stocks produce good risk-adjusted returns has existed for some time, but only recently have low-cost funds been introduced to take advantage of this.
How have low volatility stocks performed? Over long periods of time these more conservative stocks have performed in-line with the overall market, and have had substantially less risk than the market.
Several academic studies have shown that over long periods of time, low risk stocks actually performed better than the overall stock market.
In the 40-year study through 2008 one study showed that the lowest risk stocks performed the best, and the highest risk stocks had the worst returns.
Importantly, the lowest risk stocks outperformed while taking about 25%+ less risk (as measured by standard deviation or beta).
These low risk stocks have provided excellent and superior risk-adjusted returns over time.
The highest quintile of stocks in terms of volatility have produced very poor returns over the past 40 years.
Studies have shown this low-volatility anomaly to be true globally (not just in the U.
S), and distinct from several other known return factors such as value and small.
Investors must be warned that low volatility stocks tend to underperform (sometimes significantly) in rapidly rising markets.
The low volatility anomaly (and other investment return factors) There are actually several long-term investing return factors that have persisted for many years in the stock market.
Four investment return factors are the value factor, the small company factor, momentum, and low volatility.
Value stocks, small stocks, and stocks with price momentum all tend to outperform the market over long periods of time.
Low volatility stocks have shown to produce superior risk-adjusted returns over time.
We have been incorporating the value and small stock factors (and to a lesser extent the momentum factor) in client portfolios for years.
We like to "tilt" our portfolios towards factors that have shown evidence of long-term excess return and/or risk-adjusted returns.
Explanations for the low volatility anomaly How can this be? Aren't risk and return always correlated? One possible explanation is that low-risk stocks are boring to many professional and individual investors.
Most investors are short-term and want to hit a home run, to get rich quick, and to outperform other investors.
They remember the very small percentage of risky stocks that turned out to be big winners, and forget about all the risky stocks that have gone away.
People like lotteries and risky stocks with lottery like payoffs even when the math says it's a bad idea.
For these reasons, they are attracted to high risk and high volatility stocks, leaving the low risk stocks cheaper and undervalued.
Another explanation is the competitive nature of institutional investing and the fact that most professional investors are put in a "style box".
The professional investor gets a bonus and continued employment only if he/she outperforms the index and the peer funds in that same style.
They tend to chase the best and biggest short-term returns, which will generally not be the low volatility stocks.
In general, the stock market goes up over time, so it makes sense that most of them would gravitate towards the higher risk stocks that might go up the most in a rising market (ignoring the low-risk stocks).
Many investors are seeking the highest absolute returns, not the highest risk-adjusted returns.
Other benefits of low volatility stocks and funds Low volatility stocks tend to be large, financially strong, non-cyclical, and have higher than average dividend yields.
Investing in low volatility funds provides another way to diversify your overall portfolio.
In addition, by producing returns in a more stable manner your portfolio is less subject to "volatility drag".
Volatility drag is the drag on your overall long-term portfolio returns that happens when your returns are more volatile.
Which investors should consider low volatility equity funds? We believe these funds are very appropriate for older and/or more conservative investors as a less risky way to have equity exposure, with higher expected returns than their bond portfolio.
They could also be owned by more aggressive investors who wish to have steadier returns and more downside protection in their portfolio.
These funds are likely to lag the market in a rapidly rising bull market, so the most aggressive investors may find them less appealing.
Many investors today are willing to give up some of the upside in the market to get more protection against losses.
Historically, the returns of lower volatility stocks have often been about the same as the overall stock market, and the risk has been substantially less than the market.
We think funds that invest only in the lowest risk stocks are interesting, especially for more conservative investors.
Conservative investors today are likely to have large allocations to bonds, which we think are likely to produce disappointing returns over the next five years due to very low current interest rates.
These new low volatility stock funds may provide a good alternative to part of a conservative investor's bond portfolio.
They can also offer some downside protection for all investors relative to their equity portfolios.
After the wild ride in the stock market we have recently experienced, many investors are looking for less volatility in their portfolios.
What are low-volatility funds? There are several funds that invest only in lower volatility stocks.
The largest ($4.
6 billion in assets) is the Powershares S&P 500 Low Volatility Portfolio (SPLV).
This fund invests in the least volatile 100 stocks out of the 500 stocks in the Standard and Poor's 500 stock index.
Volatility is measured by the standard deviation of returns over the past year.
The stocks that make the "least volatile" list are generally large, blue-chip companies with strong balance sheets in stable (non-cyclical) industries.
We estimate the low volatility funds are about 25%+ less risky than the overall U.
S.
stock market.
The observation that low volatility stocks produce good risk-adjusted returns has existed for some time, but only recently have low-cost funds been introduced to take advantage of this.
How have low volatility stocks performed? Over long periods of time these more conservative stocks have performed in-line with the overall market, and have had substantially less risk than the market.
Several academic studies have shown that over long periods of time, low risk stocks actually performed better than the overall stock market.
In the 40-year study through 2008 one study showed that the lowest risk stocks performed the best, and the highest risk stocks had the worst returns.
Importantly, the lowest risk stocks outperformed while taking about 25%+ less risk (as measured by standard deviation or beta).
These low risk stocks have provided excellent and superior risk-adjusted returns over time.
The highest quintile of stocks in terms of volatility have produced very poor returns over the past 40 years.
Studies have shown this low-volatility anomaly to be true globally (not just in the U.
S), and distinct from several other known return factors such as value and small.
Investors must be warned that low volatility stocks tend to underperform (sometimes significantly) in rapidly rising markets.
The low volatility anomaly (and other investment return factors) There are actually several long-term investing return factors that have persisted for many years in the stock market.
Four investment return factors are the value factor, the small company factor, momentum, and low volatility.
Value stocks, small stocks, and stocks with price momentum all tend to outperform the market over long periods of time.
Low volatility stocks have shown to produce superior risk-adjusted returns over time.
We have been incorporating the value and small stock factors (and to a lesser extent the momentum factor) in client portfolios for years.
We like to "tilt" our portfolios towards factors that have shown evidence of long-term excess return and/or risk-adjusted returns.
Explanations for the low volatility anomaly How can this be? Aren't risk and return always correlated? One possible explanation is that low-risk stocks are boring to many professional and individual investors.
Most investors are short-term and want to hit a home run, to get rich quick, and to outperform other investors.
They remember the very small percentage of risky stocks that turned out to be big winners, and forget about all the risky stocks that have gone away.
People like lotteries and risky stocks with lottery like payoffs even when the math says it's a bad idea.
For these reasons, they are attracted to high risk and high volatility stocks, leaving the low risk stocks cheaper and undervalued.
Another explanation is the competitive nature of institutional investing and the fact that most professional investors are put in a "style box".
The professional investor gets a bonus and continued employment only if he/she outperforms the index and the peer funds in that same style.
They tend to chase the best and biggest short-term returns, which will generally not be the low volatility stocks.
In general, the stock market goes up over time, so it makes sense that most of them would gravitate towards the higher risk stocks that might go up the most in a rising market (ignoring the low-risk stocks).
Many investors are seeking the highest absolute returns, not the highest risk-adjusted returns.
Other benefits of low volatility stocks and funds Low volatility stocks tend to be large, financially strong, non-cyclical, and have higher than average dividend yields.
Investing in low volatility funds provides another way to diversify your overall portfolio.
In addition, by producing returns in a more stable manner your portfolio is less subject to "volatility drag".
Volatility drag is the drag on your overall long-term portfolio returns that happens when your returns are more volatile.
Which investors should consider low volatility equity funds? We believe these funds are very appropriate for older and/or more conservative investors as a less risky way to have equity exposure, with higher expected returns than their bond portfolio.
They could also be owned by more aggressive investors who wish to have steadier returns and more downside protection in their portfolio.
These funds are likely to lag the market in a rapidly rising bull market, so the most aggressive investors may find them less appealing.
Many investors today are willing to give up some of the upside in the market to get more protection against losses.
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