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By Scott Burns | 07-18-2011 05:19 PM

Low-Volatility Investing with ETFs

The top 20% of low-volatility stocks have done about as well as the broad market, but with about a third of the volatility, says Morningstar ETF analyst Sam Lee.

Scott Burns: Investing in low volatility in today's troubled markets.

Hi there! I'm Scott Burns. Morningstar's director of ETF, closed-end fund, and alternatives research.

Joining me today is ETF analyst Sam Lee. Sam, today, we're going to talk about low volatility investing. How is that even possible in today's market? What do we mean by low volatility investing?

Sam Lee: Well, naturally every stock is different. So there are some stocks that tend to move much more violently with the market swings, and some stocks that have more muted gyrations when the market goes haywire. So low-volatility investing is basically investing in those stocks with basically low beta to the market or a low relation to the market.

Burns: So we're looking for boring companies, right?

Lee: Yes, basically boring companies...

Burns: ... Boring in terms of how they act in the stock market, right?

Lee: Not exciting. They won't go up very much during bull markets, but they won't go down very much during bear markets

Burns: Right. So I'm sure our viewers will find, no surprise: Morningstar thinks slow and steady wins the race. Shocker there.

So low volatility--there's research coming out that this is a factor, right? Very similar to say, value or the size bias. Can you talk little bit about what the research is showing and how it has measured up, performance wise?

Lee: It's interesting, because classic finance says that the more volatile a stock is, the higher its expected returns, but when researchers look back at the stock market, 40 years of history, they found that the stocks with the lowest volatility have actually tended to do better. The top 20% of low-volatility stocks have actually done about as well as the broad market, but with about a third of the volatility. So that's a pretty huge difference there.

Burns: Right. So it's really not so much on the return level that volatility wins out, but it's on the risk return trade-off or even a Sharpe ratio contest?

Lee: Yes, exactly.

Burns: So instead of taking on risk and getting no return, you take on a lot less risk and get the same return, and I think that's an important concept that investors don't often get. That risk, in an efficient market, risk has to equal return, but the markets aren't really necessarily that efficient. That's why this is a factor, right?

Lee: Exactly.

Burns: So this sounds a lot like value. Is this just value in a different sheep's skin or is it different?

Lee: There's definitely some relation to value. Low volatility stocks and value stocks tend to have some overlap, but when we talk about value, true value investing is often in extremely distressed companies, companies that have terrible prospects. When we talk about value in sort of a casual ... way, those are more the Procter & Gambles; those are high-quality companies with very stable outlooks. [But] true value investing is often investing in just garbage, junk.

Burns: The worst of the worst. Near bankruptcy, low prospects.

That is something that I find when I'm out talking to investors that they don't necessarily get. They think value investing is buying those stable names, those stable consumer staples and other defensive stocks, but in academic circles, true value investing is buying the worst 90%, 80% of the companies out there in terms of financial metrics and prospects, buying all of them.

It is really kind of ... 10 of these will go to zero, and 10 of them will hopefully go up 10 times, and that's how it outperforms.

So really then what you're talking about is volatility. Low-volatility is really something that much more aligns with what the general, I would say, investor perception of value is, right?

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