Low-Volatility Strategies: Less Risk, More Reward?

At the Morningstar 2016 ETF Conference in Chicago, panelists were posed a question by Morningstar's Alex Bryan: "Why the sudden interest in low-volatility strategies?" As Bryan pointed out, low-vol strategies have garnered $41 billion in assets since their introduction in 2011.

Panelist Raman Subramanian of MSCI said investors were less exposed to these factors before 2008, but the global financial crisis of 2007-09 made lower-volatility strategies more appealing to a broader swath of investors. Panelist Craig Lazzara of S&P Dow Jones Indexes pointed out what's new is that ETF-based vehicles let you harness volatility-attenuating strategies; previously these were only active strategies. And unlike a more asset-allocation-based reduction in portfolio risk (such as a heavier tilt to bonds and cash and lower percentage in equities), low volatility equity strategies allow you to be 100% invested in equities.

The panelists also discussed the existence of low-volatility premiums in the first place. On its face, it seems paradoxical: The idea behind the capital asset pricing model is that investors are rewarded for taking higher risk; but low-volatility strategies offer higher returns for taking less risk. And recently, low-vol strategies have not only outperformed on a risk-adjusted basis, but on an absolute basis as well. Can that persist?

Panelist John Ameriks of Vanguard said going forward, while it's likely that the strategy will continue to achieve a volatility reduction, it seems unlikely that it will continue to outperform on an absolute basis.

One explanation for the existence of the low-vol premium offered by Lazzara is a lottery analogy: There are investors whose investing preferences are more akin to gambling--riskier, higher-volatility investments that have "lotterylike" risk/reward characteristics. Many people buy these types of stocks looking for a big payoff, or hoping to beat a benchmark. This persistent behavior causes markets to be somewhat inefficient, and allow the low-volatility premium to persist.

The other explanation, offered by Ameriks, is some investors are bound by low-tracking-error constraints. (Low volatility portfolios generate large tracking errors compared to traditional market-cap-weighted portfolios.) Because many investors would be unwilling to accept such a high tracking error (which, in certain contexts, is viewed as a "risk"), the low-volatility premium has a good chance of persisting.

Ameriks pointed out that there are different ways to think about "risk," however, and tracking error is not a compensated form of risk. Rather, when risk is viewed in terms of the risk of capital loss, low-volatility strategies, even with their higher tracking error, offer lower risk.

Finally, Bryan asked the panelists whether they were concerned that valuations have run up. Lazzara explained that low-volatility valuations are roughly the same as those of the S&P 500.

"As a way of thinking of timing low-volatility, we don't think valuation has much value," Lazzara said.

Subramanian agreed, adding that current valuations (at a slight premium to historical levels) are justified.

Ameriks, meanwhile, said a more important concern than valuation could be interest rates, because low-volatility could strategies could be sensitive to fluctuations in rates.