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.
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.