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The Difference Between Beta and Volatility

Paul Justice, CFA

Paul Justice: One of the hardest parts of implementing a complex investment strategy is finding the product that's right for your investment thesis. Today, we're going to talk about some of the Russell Factor exchange-traded funds and what are some of the key differences between those because sometimes investors may confuse the two funds as very similar, while in fact they are targeting different exposures.

Today, to join me in this discussion I have Chris Canova of Axioma, and I have Ed Rosenberg from Russell Investments to talk about some of the new Factor ETFs that you brought forward.

Two key components in this suite that you have right now that I think investors might confuse with each other is you have funds that target volatility, and you also have funds that target beta or basically the covariance of the market or how much the market is going to move and to what degree.

Could you talk about some of the differences between those strategies and what are some key factors that investors really need to dig into and understand?

Chris Canova: Sure. So, I think when you think about the differences between a high-beta stock and a high-volatility stock or a low-beta stock and a low-volatility stock, it's going to be the measure in which you use to calculate the exposure to that particular factor, whereas in the beta you are looking at the general sensitivity on the historical basis of that stock in a market index, such as the Russell 1000. Assets that essentially show a large amount of correlation with the markets and sensitivity to the market are going to have those high-beta exposures, while certainly correlated and high-beta stocks will oftentimes also be high volatility stocks. With volatility, you're really seeking to establish and understand how volatile has the security been historically.

So, rather than calculating the relationship between a stock and the market index, you have to ask just generally what is the volatility of that asset? So, if I am an investor and I want to make sure that I am taking an exposure if the market performs well, I am going to achieve 1.2 or 1.3 times that market exposure with the high-beta index.

If I am an investor who wants to target investing in securities that are low-volatility, I can do that in investing in the low-volatility index. I am going to be gaining exposure to assets that have displayed lower levels of historical volatility than other assets in the marketplace.

Justice: So, basically stocks that have a lot of movement would just be the volatile stocks and stocks that have a lot of movement but generally trend with the market would be the more beta segment?

Canova: Correct. So, think about it as opposed to the market trend, what's the dispersion around that asset's return and how up and down could it be over a period of time. You might have assets that over the last six months actually track the return of a market index quite well, but they bounce around quite a bit in achieving that similar market return, whereas the volatility factor will really allow you to capture the dispersion that might exist and the riskiness of an asset.

Justice: Now, Ed, you've decided to bring these products out, not only just target volatility in beta, but you've also segregated that by size. Could you talk a little bit about why that decision was made and why investors may need to apply these strategies according to the size spectrum, as well?

Ed Rosenberg: Sure. So when you think about it, most people don't just invest in the entire market as a whole. A lot of people will segment a specific area of the market, whether it's large cap or small cap. The idea here is to allow investors to choose which portion they would like to use as opposed to offering the whole slice.

If you offer the whole slice, some investors may shy away from it and look for other solutions because it doesn't quite fit into their portfolio. A lot of people will manage toward a large-cap portfolio or a small-cap portfolio. By offering the choice, you are allowing more people to come in and decide, saying, "I can use one for the large-cap if that's really where I want to be. I can use small-cap, or if I tend to cover the whole spectrum, I can actually use both."

In this case by breaking them up, you are sort of bringing a larger pool of investors in who may actually need this type of product without saying "Well, you'll just have to use the general one." And whether it fits or not is up to you. We want to offer the smart beta that people want to use and fit within that portfolio as opposed to saying, "This is how it is, and you have to fit around us." The idea is to really give the clients the ultimate solution for what they want to do instead of just basically saying, "You have to use what we put out there."

Justice: OK, I guess I will field this one to both of you, talking in regard to say risk-averse investor, if he is looking at the low-beta version of the ETF and the low-volatility version, could you talk a little bit about what his investor experience could be?

Canova: Yeah, I think from an asset-allocation standpoint, an investor really might use both vehicles because again the products allow you to not only take directional exposure to your desired factor, but you can also use them to essentially mitigate exposures that are unwanted within the context of your portfolio.

So when a lot of portfolio managers are looking at how an instrument fits into the overall context of their portfolio, using, for example, risk models and things of that nature that allow you to quantify those things, you could use both vehicles. So, for example, if you realize in your portfolio you are taking more exposure than you might like to beta and volatility, you can essentially use both instruments on the low-volatility and low-beta side in order to trim those exposures and make sure you get what you want. And again because they are designed to capture something slightly different, an investor might choose to take a position and multiple at the same time.

Justice: Great. Well thank you for helping us understand how these products are going to work in the portfolio.

Canova: Thank you.

Rosenberg: Thank you.