September 8, 2013

Low Volatility: Durable Investment Theme or Passing Fad?

Low-volatility strategies have been among the most popular investment themes in 2013, joining dividend equities and MLPs as the destinations of choice for investors—perhaps some of your clients—who are asking, “What should I do now?”

Low-volatility strategies are comparatively new to the investment landscape, with the most popular offerings launched in 2011. The two largest low-volatility ETFs, the PowerShares S&P 500 Low Volatility ETF (SPLV) and iShares MSCI USA Minimum Volatility ETF (USMV), have collectively gathered nearly $7 billion since their inception, gaining more than $2 billion of net cash flows this year alone. The iShares MSCI EAFE Minimum Volatility ETF (EFAV) and iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV) have been popular among investors interested in international equities, drawing more than $3 billion of assets since inception.

Interest in equity strategies that offer a smoother ride is a logical legacy for a generation of investors shaken by the financial crisis. Many investors, particularly those nearing retirement, realize they need to invest in equities, but hope to be cushioned from the large losses they experienced during the crisis.

However, investment strategies fall in and out of favor, sometimes at a dizzying pace, and it can be difficult to distinguish between a sustainable investment theme and an investment fad that will fade over time. We suggest evaluating whether the low-volatility theme is sustainable and if so, what factors investors should consider when selecting a low-volatility strategy.

Academic Theory: The Low-Volatility Anomaly

Some low-volatility strategies draw upon academic research examining differences in performance among low- and high-volatility stocks. One such study, from Malcolm Baker, Brendan Bradley and Jeffrey Wurgler published in 2011 in the Financial Analysts Journal, demonstrates that low-volatility portfolios have offered a version of investment nirvana: superior returns and lower risk than high-volatility portfolios. In their study, a dollar invested in the low volatility portfolio in January 1968 would have been worth $59.55 by the end of 2008, while a dollar invested in a high-volatility portfolio would have been worth only 58 cents. Academics refer to this as “the low-volatility anomaly.”

Researchers hypothesize that behavioral factors create this compelling investment inefficiency. Retail investors have a subtle but clear preference for “lottery-like” outcomes and historically have placed too much value on high-risk, high-potential-return stocks. Those of us in the institutional investment business like to think that we are above such behavioral tendencies, but academic research indicates that we too have our own herding instinct tied to the benchmarks used to evaluate institutional investment performance.

Product Design

Low volatility may mean different things to different people, a trait shared with another popular strategy, dividend investment. Understanding the differences between low-volatility strategies is critical to matching the strategy selected to the purpose the strategy will serve in a portfolio. For example, the PowerShares S&P 500 Low Volatility ETF (SPLV) relies on the low-volatility anomaly, investing in the 100 stocks in the S&P 500 that have had the lowest volatility over the past year.

The least volatile stocks may be concentrated in a few defensive sectors, so SPLV frequently will be concentrated in a limited number of sectors. Currently, more than 45% of SPLV is invested in Consumer Staples and Utilities, down from the peak we observed earlier in the year but still far above the weight of those two sectors in the S&P 500 Index. Being concentrated in defensive sectors contributed to SPLV’s performance earlier in the year, but has hurt returns in recent months.

The iShares MSCI USA Minimum Volatility ETF (USMV) takes a different approach to building a portfolio, measuring volatility more from a portfolio perspective than an individual stock perspective. USMV takes correlations between securities into consideration while applying stock and sector limitations to create a more diversified low volatility portfolio. USMV has considerably less sector concentration, with Consumer Staples and Utilities only comprising 23% of its portfolio.

Sector weights may change dramatically, as market shifts can redefine the stocks considered to be low volatility. ETFs that rebalance more frequently may be faster to respond to changes in volatility than ETFs that rebalance annually. 

Portfolio Context

Some investors are using low-volatility strategies as a standalone investment at the core of their equity portfolio. In some cases, investors in low-volatility strategies are in or near retirement and have adjusted their portfolio in recognition that they may live longer, implying a need to stay invested in equities. Other investors use low volatility as a satellite that complements more aggressive investments, such as growth-oriented equity strategies.

Different clients have different needs. For some clients, low volatility may be a better fit as a concentrated satellite holding that complements other portfolio holdings particularly for clients who have other investments that provide exposure to equities in less defensive sectors. For other clients it may be appropriate to use low volatility as a core holding as part of a diversified, portfolio-oriented approach to low volatility.

Outlook for Low Volatility

Low -volatility strategies share some common factors with popular strategies such as dividend equity strategies. Low-volatility strategies may emphasize investing in the same sectors that are popular with dividend products, such as Consumer Staples and Utilities. Consequently, low-volatility strategies and dividend equity strategies may be in or out of favor at the same time, reducing overall diversification benefits.

Low-volatility strategies were big winners earlier in the year when defensive, income-oriented stocks were in vogue; SPLV and USMV were as much as 6% ahead of the S&P 500’s returns January to April . However, as the U.S. economy has improved and interest rates have risen, investors have rotated to less defensive stocks, causing low-volatility products to lose some ground relative to the S&P 500 Index. As of July 31, 2013, the S&P 500 was about 1% ahead of SPLV and about 2% ahead of USMV year to date.

Looking forward, we would expect diversified low volatility portfolios to capture most of market upside during bull markets and preserve more capital in down markets than the average equity fund. We do, however, expect some of the benefits of the low volatility anomaly to be eroded, perhaps ironically, by increased investor interest in the category. 

Very few profitable academic anomalies remain a secret, and more money in a strategy almost always makes it harder to make money from the strategy. Even without the promise of higher returns, clients may appreciate a less bumpy ride. And if such a ride leads to less anxiety for the client, that is a good thing for clients and advisors. 

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