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By Michael Rawson, CFA | 06-18-2012 01:00 PM

Low Volatility Is Not a Substitute for Value

S&P's Craig Lazzara discusses several approaches to factor-based investing and why individuals should be aware of the differences in index construction.

Mike Rawson: I'm Mike Rawson, ETF analyst with Morningstar. We're talking today about factor investing, and joining me is Craig Lazzara, a senior director and product manager at S&P Indices.

Craig, thanks for joining me.

Craig Lazzara: Mike, thank you for having me.

Rawson: Craig, what is meant by this term factor investing? It's kind of a newer term that's been associated with some of the new ETFs that are out there. How is factor investing different than traditional index investing?

Lazzara: One might think of factor investing as a second- or third-generation of traditional indexing. If you think of cap-weighted indexes like the S&P 500, for example, as the first generation, factor investing is either the second or third, depending on how you count. But the thing that factor indexes have in common is that they try to embody a quality or a factor, obviously, hence the name, but a quality or an attribute that many stocks have and it's a quality or attribute with which excess returns are thought to be associated. For example, sometimes people think of low valuation as a factor of return; people have thought for years of beta as a factor of return, meaning an attribute with which certain behaviors are associated.

To the degree that it's possible to look at what an active manager does and subdivide that into an active part and a part that really comes from a certain exposure to a set of attributes that are more or less always there, it's appropriate and possible now to be able to dissect that active management process and say that a certain portion of what this active manager does is really just providing you with exposure to a factor, to a set of attributes that give certain return patterns. And those factors indexes can be used obviously either as benchmarks for that kind of manager or as the basis for a passive product.

Rawson: How should I be using these in my portfolio? Is this something where they would form the core of my portfolio, these factor ETFs, or would I go out and buy the S&P 500 as a core of my portfolio and then maybe supplement that with some satellite positions, some tilts using the factor ETFs?

Lazzara: I would never tell you not to use the S&P 500 for any purpose you're inclined to use it for, so certainly, you should do that. I think in terms of how factor indexes and product based on factor indexes should be viewed, it really depends on the factor you are talking about.

I'll give you an example. We launched about a year and two months ago, two new indexes and then soon thereafter there was product on these indexes. The indexes were called S&P 500 Low Volatility and S&P 500 High Beta. They are twins, basically; they came out on the same day. Methodologically they are very similar, except that the Low Volatility Index is designed to give you exposure to the least volatile members of the S&P 500 and you can think of low volatility as a factor in the sense we are mentioning. The High Beta index, as the name suggests, is designed to give you exposure to the stocks in the 500 with the higher systematic risk, and again people thought of beta as a factor for many, many years.

Now, the way in which those two indexes behave--they were designed to be different, and they are different. What High Beta will do is that in a strong market environment, it will do very well; it magnifies the returns of the market. In a weak environment it will do quite badly because it magnifies the returns in a negative direction, as well. People tend to look at that pattern of returns of High Beta and view it more as a trading vehicle or a tactical vehicle than a core position.

On the other hand, if you look at Low Volatility, it tends to give you participation in rising markets, not necessarily full participation, but certainly substantial participation in rising markets, and it tends to give you some protection in falling markets. So, your overall pattern of returns is muted relative to what it would be in a cap-weighted index, or the parent index from which these factor indexes were derived.

That being the case, a lot people will view a low-volatility approach as a potential core position because it gives them as investors, the possibility of participation in rising markets and at the same time, it shields them from some of the worst damage in falling markets.

Rawson: Craig, you've done a lot of work on this low-volatility theme, factor phenomena, that's observed out there in the market where low-volatility stocks tend to outperform, on a risk-adjusted basis, these high-volatile stocks. That theme holds a lot of appeal, particularly in this current economic environment where economies are really volatile, the stock markets seem to be more volatile than usual, times are uncertain, and we are in the lower-return type of world where interest rates are really low. You mentioned the launch of the S&P Low Volatility ETF, its symbol is SPLV. That was one of the most popular ETF launches of last year; it already has more than a $1 billion in assets. Can you talk a little bit more about how that particular index is constructed?

Lazzara: With the S&P 500 Low Vol Index, one of the things I think that has led to its appeal is that it's really very simple. And I say that in the context of warning that for anyone listening to these words, sometimes you get at the low-volatility indexes and what are some of that minimum-variance approaches, and they are very complicated mathematically.

We set out to try to give you a simple way to access low volatility in this index, and it's very simple. You start out with the 500 stocks in the S&P 500, you look back a year, and you measure the actual volatility of each stock in the 500, just using 252 approximately daily returns. The 100 stocks with the lowest volatility, the lowest standard deviation, become the constituents of the Low Vol Index, and those constituents are then weighted in inverse proportion to their volatility. So, if I have one stock with the volatility of 12% and another stock with the volatility of 6%, the 6% stock gets twice the weight as a 12% guy.

Now, it turns out that both of those steps, the selection of the least volatile stocks and the weighting by the inverse of volatility, both of those contribute to the overall return pattern. In other words, if you simply took the least volatile stocks and cap-weighted them or equal-weighted them, the result would not be as good as the result in fact that we got.

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