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Low-Volatility Investing with ETFs

Scott Burns

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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Lee: Yes.

Burns: So we're talking about those quality names. How does it match up with other research that's out there about high-dividend-paying stocks performing better over the long run, etc.? Is there a lot of correlation to that as well?

Lee: Yes, there is. They are all connected in the sense that low-volatility stocks, value stocks, tend to have less investor interest. They tend to be less prone to attracting the type of investors who are overly optimistic about the market prospects. And the market has a long bias. It's very difficult to short stocks, relative to buying them and holding them.

So, stocks that can get overvalued can tend to actually become overvalued. So, small-cap growth stocks have historically been amongst some of the worst-performing stocks in almost every market studied.

Burns: And I don't think that's any secret. One thing: When doesn't this work? Because that is one of the issues I think with some of these academic factor models, too, is that, you think about value, and it's often cited that over 20 years, value always wins out, always means growth. But what a lot of people don't understand is that there was a two-year period in that 20 years where value really outpaced growth, and then for the rest of the time it was kind of flat. And the trick is you don't know when in those 20 years it's going to happen. So how does low-volatility work?

Lee: So admittedly it's similar. Low-volatility tends to underperform unsurprisingly when there are massive bull markets, like the '90s. So a low-volatility strategy during the '90s would have underperformed the market by well over 10% annualized.

But the great thing about low-volatility is during the times when it really matters, during bear markets when every other stock is getting killed, these strategies don't lose as much money.

So, if you're looking for a more steady, total return type of strategy rather than just keeping up with the Joneses, low volatility is pretty good option.

Burns: All right. Obviously you can play this with some individual stocks. We mentioned some of those names, but one of the things that, again, this academic factor study requires is that you have to buy all of the stocks that fit into the categories, and that's where ETFs come in.

So, for investors out there looking to invest and kind of capitalize on some of this research around low volatility, what are some of the ETF names that we're suggesting right now?

Lee: I am going to start like a broken record, but Vanguard Dividend Appreciation ETF VIG has one of the lowest volatilities out of any large-blend stock ETF on the market.

There are actually some ETFs coming out that specifically target low volatility. So, Russell 1000 Low Volatility ETF.

Burns: And that's coming out from Russell?

Lee: Yes. There is even a PowerShares S&P 500 Low Volatility ETF. But these ETFs are kind of new. They are not very tested. So, it might actually just be better to get the next best thing, which is a more value or quality type of ETF--just broad value exposure. And more importantly, it's what you don't invest in that will help your returns, and that's basically extremely growthy-type stocks. The smaller and the more growthy, the more dangerous it is, historically speaking.

Burns: So, doing screens based on growth and beta to help weed out things in your portfolio can help just as much as doing screens looking for that low-beta and high-value combination. So, I think that's a great point for investors when they are doing their portfolio X-rays and other portfolio maintenance, regardless.

So, Sam thanks for joining me. ... You always bring great aspects of what's happening in the latest and greatest in the academic circles to Morningstar. So, thanks for being here and thanks for sharing.

And I'm Scott Burns with Morningstar. For this and other ETF news, please check out Morningstar.com's ETF Center and Morningstar's ETFInvestor newsletter.