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Is a Low-Volatility Approach Right for You?

Christine Benz
Alex Bryan, CFA

Christine Benz: Hi, I'm Christine Benz for Low-volatility strategies have been gaining traction in recent years. Joining me to discuss whether a low-volatility investment deserves a slot in your portfolio is Alex Bryan. He is an analyst with Morningstar.

Alex, thank you so much for being here.

Alex Bryan: Thanks for having me.

Benz: You noted in a recent article, Alex, that these low-volatility strategies have been gaining assets. We've seen a proliferation of products in this space. What do you think is driving that interest?

Bryan: Well, I think it's twofold. First, in the past several years, there have been a lot of academic studies that have been published that have shown that stocks with low volatility have historically offered better a risk/reward trade-off than the market overall. That makes for a pretty good marketing story. Now, on top of this, a lot of investors were looking for a lower-risk way to invest in stocks, particularly after their experience in 2008. So, I think it was a combination of this research push and investor pull that led to the creation of the so many new low-volatility strategies.

Benz: In terms of the product construction, most of these are index products, correct?

Bryan: That's right.

Benz: So, how do most of these funds attempt to winnow down the total stock universe to the low-volatility group?

Bryan: Most of these funds attempt to target stocks that have exhibited low volatility in the recent past. Now, different funds take different approaches to do this. For example, the PowerShares S&P 500 Low Volatility ETF (SPLV) basically targets the 100 least-volatile members of the S&P 500, and then it weights its holdings based on the inverse of their volatility so that the least-volatile stocks get the biggest weightings in the portfolio.

Now, iShares MSCI USA Minimum Volatility ETF (USMV) takes a more sophisticated approach. It uses a more complex algorithm to design a low-volatility portfolio with a couple of constraints in mind designed to preserve diversification. But it looks at not only individual-stock volatilities but also the correlations across stocks. So, it's a little bit more sophisticated, but they both try to get you to the same place.

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Benz: There have been some research papers recently that have tried to poke holes in the low-volatility strategy. I think the concern has been that anytime you're looking at backward-looking data that shows that a certain category outperforms you've got to wonder if that will be persistent. Can you summarize some of the objections to a low-volatility strategy?

Bryan: Sure. One of the chief criticisms that was levied against low-volatility strategies is that they are not really doing anything new. The critique was made that the attractive performance characteristics of low-volatility stocks really comes from the strategies biased toward stocks that are trading at low valuations and stocks with high profitability. Those characteristics have been associated with higher expected returns over time. So, the implication of this critique is that it may be more efficient to directly target stocks that have low valuations and high profitability, but that increased exposure to bonds is a way of mitigating volatility rather than using the low-vol strategies, which by accident overweight these securities and may not have consistent exposure to stocks that have those characteristics.

Benz: You decided to test that thesis. You looked at how a low-volatility strategy would stack up to some of these other strategies. The methodology was somewhat complicated, but I'm wondering if you could break down the outcome of your research. What were the takeaways?

Bryan: The biggest takeaway is that I couldn't quite replicate the attractive risk and return characteristics of the low-volatility index using a more targeted approach where you specifically target stocks trading at low valuations and high profitability and then allocate the remaining portion of the portfolio to bonds. That other approach doesn't seem to quite get you to the same place that a simple low-volatility strategy would get you to. What this means is that while the critique that's been levied against the low-volatility strategies has some technical merit, it's of limited practical use because low-volatility strategies can still give you a better outcome than specifically targeting value or profitability stocks.

Benz: The time period you examined for this research in which low-volatility strategies looked pretty successful was roughly 1993 through 2014. I'm wondering if there is anything specific about that 20-year period that would have been particularly hospitable to low-volatility stocks. Is there anything you can think of?

Bryan: During that period, we had two very significant bear markets, and those are the periods when low-volatility strategies tend to shine. The strategy doesn't tend to hold up quite as well during a stronger bull-market period. So, to the extent that we have a more-extended rally going forward, you would expect the low-volatility strategies to not look quite as good on a relative basis.

Also, during that period, low-volatility strategies tended to underweight growth stocks, particularly in the early 2000s. That certainly did contribute to the attractive return characteristics over this particular window as did falling interest rates. Low-volatility stocks do tend to be a little bit more sensitive to interest rates than the market in general. That's because these stocks tend to have relatively stable cash flows. And so when times are bad and interest rates fall, these stocks tend to benefit more from the lower rates than stocks that are more cyclical. But by the same token, when rates rise and the economy strengthens, a lot of these companies may not have the same type of cash flow growth to offset the negative impact of higher rates.

Benz: So, that's a potential caveat given that going forward we may have more of a headwind from rising rates.

Bryan: Absolutely.

Benz: Many investors have been inculcated in this idea that if you are getting a lower-risk portfolio, you'll need to settle for lower returns. But your research and some of this other research supporting low-volatility strategies kind of runs counter to that. How do you square those ideas?

Bryan: Well, it's important to keep in mind that low-volatility strategies won't always keep pace with the market--and, in fact, there have been long stretches of time when these strategies have lagged the market. From 1931 to 1965, low-volatility strategies actually would have given you lower absolute returns than the market. Yet, over that period, they've offered a better risk/reward trade-off. So, I think there's still some merit there.

Now, one of the reasons why I think it's reasonable to expect low-volatility strategies to give you a better risk/reward trade-off is that these stocks may be relatively unattractive to investors who are trying to beat a benchmark because they do tend to lag during market rallies and they may have lower expected returns than the market overall even over a longer period of time. So, a lot of investors may not be attracted to these relatively boring stocks, and that can cause their prices to be depressed, allowing them to offer more attractive returns relative to their risk. That relative terminology is important, but I think it's something that can mean a lot to investors looking to improve their risk/reward profile going forward.

Benz: You have been looking closely at some of the products that use a low-volatility strategy. Can you discuss the ones that you think are best of breed within this low-volatility group?

Bryan: Sure. I mentioned the iShares MSCI USA Minimum Volatility fund a little bit earlier. That's an interesting strategy because it only charges 15 basis points. It is an index fund, but it has some nice constraints in place to limit sector bets. It preserves diversification by anchoring its sector weightings to a broad market-cap-weighted benchmark. That allows you to take advantage of the low-volatility effect but still use this as a core holding where you don't have to worry about loading up on utilities or consumer-defensive stocks, for example. So, that's an interesting fund.

Vanguard recently launched a fund called Vanguard Global Minimum Volatility (VMVFX), which uses a very similar approach to the iShares fund except it invests globally. Now, that could introduce currency risk, but this specific fund hedges out its currency exposure as a way of further mitigating volatility. So, I think those two funds are interesting ways for investors to take advantage of this effect.

Benz: My last question is if I'm intrigued, if I'm attracted to this low-volatility strategy, how would I think about using such an equity fund in my portfolio? Would I supplant my other equity holdings with this product or use it as a supplemental holding?

Bryan: There are a couple of ways you could think about this. If you're looking to earn higher expected returns over the long term, what you could do is you could allocate a greater portion of your portfolio to stocks and a smaller portion to bonds. That would allow you to increase your expected returns while maintaining a similar volatility profile. Now, the drawback of doing that is that you're sacrificing some asset-class diversification benefits by reducing exposure to bonds. If you're a more risk-averse investor, what you could do instead is maintain a comparable asset-allocation profile as before, but maybe in the equity portion of your portfolio shift more toward these low-volatility strategies. You may be giving up a little bit of expected return, but you'll likely improve your risk/reward trade-off.

Benz: Alex, thank you so much for being here to share this research.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for