6 Questions About Low-Vol Investing

At the 2017 Morningstar ETF Conference, Morningstar's Alex Bryan talked with Fidelity's Darby Nielson, Powershares/Invesco's Jason Stoneberg, and MSCI's Raman Subramanian about why low volatility strategies work, whether low-vol stocks are overpriced today, and how investors can incorporate these strategies into their portfolios.

Why does this anomaly exist and will it persist? Stoneberg said the anomaly exists because low-volatility stocks can be difficult for investors to own. Some investors literally can't own these stocks, due to their tracking error. Other investors, meanwhile, prefer high-flying stocks that they think hold the potential for greater returns.

Subramanian agreed. As long as investors and analysts remained more focused on "glamour stocks" than those with less volatility, the anomaly should persist.

What are the performance expectations for low volatility strategies? One would expect low-vol strategies to achieve risk-adjusted returns that beat the market over time.

Stoneberg argued that these strategies don't need to offer all-out market-beating performance to be attractive. They can match the market at a lower risk level, or return slightly less than the market but with much less volatility.

"All it has to do is have a higher Sharpe ratio to be relevant," he noted.

Nevertheless, Subramanian said there can be periods during a market cycle when low volatility strategies beat the market.

"Any risk premia has its own cycle," he explained.

Nielson, meanwhile, thinks there's a misconception that low-vol strategies will outperform.

"It's not necessarily an excess return-type product," he said. Further, there is the potential for loss. "If you buy a low-vol fund, it can underperform over periods of time and even go down."

Are low vol strategies overpriced today? "Right now, low-vol strategies are a little expensive," admitted Nielson. "I think there should be some concern there."

When low vol is expensive, it will tend to underperform going forward, he added. However, these strategies are less expensive now than they were last year. And outside of the U.S., they're even less rich.

Subramanian has a slightly different take. He says valuations among low-vol stocks today are "not alarming." He focuses on where low-vol stocks are trading relative to their histories, not relative to the rest of the market today. In that sense, low volatility stocks may be pricier than theyve been during some periods, but not as rich as they've ever been. He also notes that low vol stocks are a lot like insurance: People flock to them when they are looking for protection. So if there's a trigger that drives investors to seek that protection, valuation will be less important.

According to Stoneberg, valuation is just one of many inputs to consider when evaluating a factor.

"Currently, low vol is richer than it has been historically and richer than other factors," he said. But he finds that the relationship between valuation and future returns is tenuous when it comes to low-vol strategies. If the basket of stocks in the strategy turns over rapidly, valuation is a less reliable indicator of subsequent returns.

How can an investor use low-vol strategies in a portfolio? If you have a long-term horizon but have concerns about overall market volatility, low-volatility strategies can be a good investment for you, noted Nielson.

Subramanian added that low-vol strategies can be useful for investors who want to dial down risk without changing their asset allocations.

"Low-vol strategies aren't a replacement for bonds," said Subramanian. Fixed income, cash, and equity each have a role in a portfolio, he noted, and low-vol strategies are a tool to use to dampen risk in a portfolio's equity sleeve.

Are low vol strategies more sensitive to rising rates than other strategies? "It seems intuitive that would be the case," said Nielson. "Empirically, yes, there is a negative correlation. When rates go up, low vol underperforms."

Why is that? Nielson explained that yields rise because bond prices are going down, and bond prices go down when we're in a "risk on" environment--and low vol wouldn't do well in that environment.

But Subramanian countered that even when rates are rising, markets can be volatile. And low-vol strategies can do well during those volatile periods.

Are there different ways to execute a low vol approach? "There are a lot of different flavors of vol products out there," noted Nielson. Some strategies simply target stocks with low volatility while others use an optimization process. Still others target low vol stocks but apply a rules-based process that helps limit unintended bets.

Nielson is a fan of the latter, largely because of the simplicity of it.

"Factor investors want to understand what's going on under the hood," he said.

"We think the optimization approach is far more powerful, especially outside of the U.S.," said Subramanian. He said optimization provides much needed flexibility and nuance when it comes to limiting unintended bets and therefore avoiding blow-ups.