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By Michael Rawson, CFA | 09-18-2014 02:00 PM

Low Volatility Earns Its Keep in Tough Times

Low-vol strategies may limit investors’ upside in a bull market, but their truncated downside risk may be worth the trade-off in the long run, says S&P Dow Jones Indices’ Craig Lazzara.

Mike Rawson: Hi, I'm Mike Rawson with Morningstar. I'm here today at the Morningstar ETF Conference, and I am joined by Craig Lazzara. Craig is the global head of index investment strategy with S&P Dow Jones Indices.

Craig, thanks for joining us.

Craig Lazzara: Thank you. Happy to be here.

Rawson: Craig, ETFs have gained popularity, in part, because passive investing is becoming more popular but also because investors are interested in nontraditional types of indexes. Can you talk about some of these nontraditional indexes and what investors are using them for?

Lazzara: I think the way to think about that question, Mike--and it's a great question--is to frame it in terms of the way the index business has evolved. In the beginning, which means 30 or 40 years ago, the index world was limited to what I would classify as first-generation indices--or things like the S&P 500, the Russell 1000 in the U.S., IFA internationally--all of which are cap weighted indices designed to be a proxy for an asset class. (In this case, it would be the equity assets.) And they were, as you said, a very good way for people to gain exposure to the market. Reliably, over time, most active managers underperform them; so, they are a viable strategy. And that's where indexing became popular years ago.

And then, as that popularity grew, there was a second-generation of indices; I'll call them the extensions and subdivisions of the first: Sectors of the S&P 500, or individual countries, or growth and value divisions are some that are popular. But again, they are all cap weighted and designed to represent a proxy instead of the subset of an asset class.

You come to third-generation--what we like to call factor indices. I know you at Morningstar like to say strategic beta, which is a perfectly good term. Think of factor indices as vehicles that are designed to give you exposure to a pattern of returns that you as an investor might find congenial.

Another way to say that--and it's not a very succinct way--is to say that factor indices or strategic beta gives you access to patterns of return that in former years you would have had to pay an active manager active fees to get. And now, you can "indicize" those strategies in order to have access, more efficiently, to patterns of return or factors of return that an investor finds useful.

Rawson: So, you're getting exposure to factors that have been associated with excess return historically in the past, and some of these factors that have become popular recently. Indexes have been developed and funds have been developed based on these factors such as low volatility. What kind of exposure are you getting with low volatility? How are these low-volatility funds intended to be used?

Lazzara: Low volatility is a very interesting factor. The academic research goes back to at least the early '70s because one of the things that the capital asset pricing model predicts is that the return of a stock should be proportionate to its beta, its systematic risk. And it turns out that's not a very good prediction for high levels of beta.

So, the initial work, I think, was done by Fischer Black and some colleagues who were concerned about this challenge to the new capital asset pricing model. And they had some explanations for why this effect took place--where lower-volatility or lower-beta stocks seem to do relatively better than you would predict compared with higher-volatility or higher-beta stocks. And there are some other explanations other than the one they came up with.

But what we do in our low-volatility indices is to own--for example, in the case of S&P 500 Low Volatility--the 100 least volatile stocks in the S&P 500 and weight them inverse to volatility. So, a stock with a vol of 20 gets half the weight of a stock of a vol of 10. And hold that for a quarter and then rebalance.  There are two things that are worth mentioning about that particular approach to the low-vol factor. One is that volatility tends to persist over time. So, stocks that had low volatility for the last year, typically have low volatility going forward. So, if you want low vol going forward, buy whatever was low vol in the past; that's not a bad way to do it.

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