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2 Ways to Limit Volatility

Alex Bryan, CFA

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Alex Bryan: Low-volatility strategies have gained popularity over the last couple of years. Academic research has shown that stocks with low volatility tend to outperform their more volatile counterparts. Researchers believe this is partially because investors face leverage constraints, and they tend to overweight riskier stocks in an attempt to boost their returns and neglect some more boring, steady-Eddie stocks, which may cause them to become undervalued relative to the risk.

There are two approaches that investors can take advantage of this low volatility effect with ETFs. One is offered by PowerShares and the other is offered by iShares. The PowerShares series of low-volatility funds attempt to create a low-volatility portfolio by targeting stocks that have low volatility and then weighting them by the inverse of their volatility, so that the least volatile stocks receive the greatest weightings in the portfolio. In contrast, iShares, they consider the correlations between stocks in addition to their volatilities.

To illustrate the differences between these two approaches, consider the case of a company that just makes umbrellas and a company that only make sunblock. Individually, these stocks may not have low volatility, so they maybe excluded from the PowerShares series of funds. However, when they're combined within a portfolio, the volatility of one may offset the others. They may reduce the portfolio's volatility. IShares might include these types of stocks.

In addition, the iShares funds impose a series of constraints in order to limit turnover and improve diversification. For example, these funds will anchor their sector weightings to a market-cap-weighted benchmark. As a result, these funds may be better core holdings for long-term investors because they preserve diversification to a greater extent than the PowerShares funds and they allow investors to take advantage of this low-volatility effect.