Strategies and Picks for Low-Volatility ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. A bevy of low-volatility ETFs have hit the market in recent years. But there's significant variations among them. Joining me to discuss some of the key factors that investors should consider when looking at low-volatility products is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: In the most recent issue of ETFInvestor, you wrote about low-volatility strategies, and you put forth a framework for evaluating low-volatility products and I want to get into that. But first, let's talk about the thesis behind low-volatility strategies. Why should investors consider potentially such an approach for their portfolios?

Bryan: The basic idea behind a low-volatility approach to investing is targeting stocks that have historically exhibited low risk. The basic idea here is that these types of strategies are designed to give you a better risk/reward trade-off than the overall market. In other words, the idea here is to offer better downside protection when the market corrects and to still give you some equity upside participation. These types of strategies will likely lag in a strong market environment, but over a full market cycle, you could expect, I think, to earn a better risk-adjusted set of returns than the overall market. You are looking for a better risk/reward trade-off here.

Benz: If I am an investor, say, of a very long time horizon, I know myself to not be risk-averse, so, I don't get spooked when the market is falling or is volatile. Do I have a reason to consider a low-volatility strategy? For whom do you think these products are particularly appropriate?

Bryan: It's really most appropriate for investors who are more risk-averse, who might be more inclined to sell out of their equity positions during a market correction. It's important to have the right expectations going in. These are still equity strategies. They are still going to lose value when the market sells off. But they should hold up a little bit better than the overall market in those tough economic environments. If you are more risk-averse, but you still want to stay invested in equities, I think this is a good strategy for those types of investors. These do tend to provide better downside protection and bounce around a little bit less than the overall market. If you are risk-averse, it could be a good option for you.

Benz: You recently wrote about a framework for evaluating these low-volatility products. Let's talk about some of the key things that investors should have on their radar when they are comparing one low-volatility product, whether ETF or a mutual fund, to another?

Bryan: One of the most important things to start out with is understanding what the selection universe is for the fund, because that's going to have a big impact on the end result in terms of its risk characteristics. Typically, large-cap stocks tend to less volatile than small-cap stocks, and U.S. stocks tend to less volatile than foreign stocks because you don't have that currency risk. If you are looking really to cut risk down, starting with the U.S. large-cap space, that actually might be a really good starting point.

Now, that being said, the performance advantage of tilting toward low-volatility stocks has actually tended to be the largest among the smallest-cap stocks. Now, small-cap low-vol stocks are riskier than large-cap low-vol stocks. But if you are really looking for this performance improvement from tilting toward low-volatility stocks, you tend to get more of that in the small-cap space. It's important to keep your starting universe in mind.

The second point that I think is really important is to understand whether or not the fund that you are looking at is using a holistic approach to portfolio construction or whether it's looking for individual stock characteristics. What I mean by that is, some funds basically target stocks that have low risk characteristics and they don't look at how those stocks interact with each other or what the correlations across those stocks might be. You may end up with a portfolio that's very concentrated in utilities and consumer defensive stocks, for example, because those stocks tend to have low volatility. But there may be risk associated with those big sector bets that you may not get if you were to look at the correlations across those stocks and say, you know what, I don't just want to own the least volatile stocks in the market; I want to construct a portfolio that's expected to have low volatility.

One way to do that is to own stocks that have low correlations with one another because what you really care about as the end investor is the riskiness of the entire portfolio. Funds that use that more holistic construction approach that considers correlations as well as individual stock volatility is probably more appropriate for a core equity position for someone who wants to be better diversified across different sectors and different areas of the market. I think that's the most important thing to look at as you consider these low-volatility funds. That's definitely a good starting point for considering these funds.

Benz: You wrote that some of these funds do have sector constraints in terms of how they are managed. Some of them will say, we don't want X sector to grow larger than X percent or whatever. They might have some rules in place to ensure that they are not overly concentrated in sectors.

Bryan: That's right. And while those sector constraints may slightly reduce the style purity of the fund, we generally view them pretty favorably because certain types of sector bets, especially if you are more risk-averse, may not be desirable, because they are a source of active risk. They are not always going to work out. For example, if I didn't constrain a low-volatility portfolio, I would probably end up with a large weighting on utilities. If interest rates were to tick up more quickly than investors expect, well, that's a source of risk that could hurt those stocks. Maybe I don't want that type of risk in my portfolio.

Generally speaking, if you really are more risk-averse, having sector constraints in place is probably a good thing even though it may cause you to own some stocks of higher absolute volatility than you otherwise might have. I think the benefits from the diversification standpoint offset that downside risk.

Benz: You brought some specific low-volatility ETFs that you like. Let's with the core type large-cap products. Let's cycle through a couple of the ones that you like.

Bryan: One of the ones I really like for core exposure to the U.S. market, again for risk-averse investors, is the iShares Edge MSCI USA Minimum Volatility ETF; the ticker is USMV. What this portfolio tries to do is it tries to construct the least volatile portfolio possible under a set of constraints, which include limiting sectors tilts to the broader market and limiting unintended factor tilts. But essentially, this is using that holistic approach where it's not just looking at individual stock volatility, but it also looks at how stocks interact with each other in the portfolios, the correlations across stocks. This has actually been a wildly successful fund. It's effectively reduced volatility compared to the market index. It's also exhibited much lower downside risk than the parent benchmark. It's actually done quite well, and I think it's likely to continue to provide that attractive risk reduction characteristics going forward.

Benz: There's another large-cap fund that you like AUIEX?

Bryan: That's right. This is the AQR Large Cap Defensive Equity Fund. It uses a similar type of holistic portfolio construction approach. The difference here is that this fund is not just looking at statistical measures of risk like volatility and correlations, but it also looks at fundamental measures of risk like quality. It's looking at profitability, earnings volatility, probability of default. It's looking at these additional measures of quality to supplement the statistical measures of risk and provide a more holistic view of what the riskiness of the stocks may be. That has also been a very successful fund at cutting risk and providing attractive risk-adjusted performance.

Benz: AQR, I know it's a very well-regarded firm, but not the cheapest game in town typically. So, let's talk about that.

Bryan: That's right. This fund charges 41 basis points where the iShares fund charges 15. The difference here, the reason why it's charging a little bit more, is this is an actively-managed fund. It's quant active, so it's a set of rules but it doesn't track a benchmark. The managers have a bit of discretion to determine whether any adjustments to the model are needed or when they want to rebalance the portfolio. There's a few adjustments that they can make to the process. They have been able to recoup their fee at least during the period that the fund has been around.

Benz: In terms of small-cap exposure in the low-vol space, let's talk about a fund that you like there.

Bryan: For investors that are really looking to take advantage of this anomaly where the low-volatility stocks have provided really attractive risk-adjusted performance, you actually get a lot of that juice out of the strategy from the small-cap low-volatility stocks. Now, it's important to keep in mind that small-cap low-volatility stocks are going to be more volatile than large-cap low-volatility stocks. But again, if you compare the performance of the small-cap low-volatility strategy against a broad small-cap index, you will see a better improvement in performance there, at least historically.

One of the funds that I like for exposure to this area of the market is PowerShares S&P SmallCap 600 Low Volatility ETF; the ticker is XSLV. This fund charges 25 basis points. And effectively, what it does is it ranks all stocks in the S&P SmallCap 600 Index based on their volatility over the last 12 months, and it targets the least volatile 20% of the market. Then it weights those stocks by the inverse of their volatility so that the least volatile stocks get the biggest weightings in the portfolio. Now, this fund does not constrain its sector weightings. It does not constrain its turnover. It doesn't constrain anything. It's really giving you a very potent exposure to low-volatility stocks. But because you don't have those risk constraints in place, this is really more appropriate as a satellite holding for someone who really wants to take advantage of this academic effect that's been documented in the literature.

Benz: And finally, a globally-oriented low-vol fund. This one from Vanguard.

Bryan: Vanguard Global Minimum Volatility Fund--this is a mutual fund, but it uses its holistic-type approach that iShares and AQR use for their minimum-volatility funds. This fund is a bit unique in that it is constructing a low-volatility portfolio using global stocks, the U.S. stocks, international stocks, all across the entire market cap spectrum. What it does to further mitigate risk is for the foreign stock portion of the portfolio, it applies a currency hedge. That's an effective way of reducing volatility even further.

One of the benefits of going global with a minimum-volatility approach is that you have more opportunities for diversification. This fund is able to take advantage of low correlations across different markets to construct the least volatile portfolio possible. If you are looking for a one-stop shop for your equity exposure and you are more risk-averse, this is a really compelling option that's pretty attractively priced.

Benz: Alex, always great to hear your insights. Thank you so much for being here.

Bryan: Thank you for having me.

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