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Low-Vol Strategies May Underperform When Rates Rise

Alex Bryan, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Could low-volatility strategies be in for tough sledding? Joining me to discuss that topic is Alex Bryan. He's director of passive strategies research for North America for Morningstar.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, before we get into this risk that you talked about in a recent issue of ETFInvestor, I'd like to start by talking about what is the fundamental case for low-volatility investing. This has been kind of a trend in the past few years. What is it based on? What are investors looking for as they have been gravitating to these low-volatility strategies?

Bryan: Well, most obviously you get a reduction in volatility compared to the broader market, so that's an appealing benefit for a lot of risk-averse investors. These strategies tend to bounce around less than the market, they also tend to hold up better during market downturns. What you give up typically is performance in a stronger market environment. But I think the strongest reason to adopt a low-vol strategy is if you believe that the strategy will offer better risk-adjusted performance over a full market cycle. It's pretty easy to reduce risk by just shifting money from stocks to bonds, but I think low-volatility investing has merit because it's likely to give you better risk-adjusted performance.

There's a couple of theoretical reasons for that. I think one of the strongest cases or explanations that was put forth was that a lot of active managers out there are trying to beat a benchmark, but in order to do that a lot of times they shift toward riskier stocks, because those stocks often have higher expected returns as compensation for their risk. That causes those stocks to become overvalued relative to their risk. Similarly, their collective neglect of the safer, more steady-Eddie stocks can cause them to become undervalued relative to the risk, allowing them to offer attractive risk-adjusted returns over a full market cycle. So, I think there is some theoretical merit, and it's definitely been borne out in the data over the last several decades.

Benz: OK. So, let's take a look at a couple of the largest low-volatility ETFs. They are a little different. So, let's talk about the indexes they track and the construction of those indexes.

Bryan: Sure. So the two major funds out there are the PowerShares S&P 500 Low Volatility ETF, which tracks an S&P index, and the iShares Edge MSCI Minimum Volatility USA ETF, which tracks an MSCI index, it's a bit more complicated. So let's start with the PowerShares Fund. So, this fund basically takes all the stocks in the S&P 500, ranks them based on their volatility over the past 12 months, and then it targets the stocks--the 100 stocks that have the least volatility over that period--and then weights them by the inverse of their volatility, such that the least-volatile stocks get the biggest weighting in the portfolio. Now it does that without any constraints on sector weightings or turnover anything like that. So that can lead to some pretty concentrated bets. Right now, for example, that fund has a pretty heavy position in utility, say consumer defensive stocks, as you might expect.

The iShares Fund uses a bit more of a holistic approach. So, it's using an optimization algorithm that tries to construct the least-volatile portfolio possible under a set of constraints. So, it's looking not just at individual stock volatility, it's also looking at how stocks interact with each other in the portfolio to affect the overall volatility. And it constrains the sector weighting so that it prevents a large tilt toward utilities, for example. So, it reins those in a bit to look a bit more like the market and preserve a diversification. So those are two very different avenues to get to the same type of outcome, which is lower volatility.

Benz: OK. It seems like an obvious risk to a lower-volatility strategy, which you alluded to, is that potentially in certain market environments, especially really robust kind of sometimes called risk-on markets, that you would lose ground to say even a broad market index during such a time frame. So that's one risk that is out there and investors presumably acknowledge that in buying one of these funds. 

But you highlighted a risk that perhaps investors haven't been paying a lot of attention to in part because we haven't really had this sort of market environment, but you looked at the interest-rate sensitivity of low-volatility stocks. You went back over time to look specifically at periods of rising interest rates to see how these low-volatility stocks performed. Let's talk about that. You found that, in fact, the low-vol group may, in fact, be somewhat susceptible to rising-rate environments.

Bryan: So, I looked at the performance of these low-volatility indexes since their inceptions back, well, their back-filled inceptions, back in the early 1990s, in the case of the PowerShares fund. And what I found was that the indexes tended to be very sensitive to changing interest rates. They tended to outperform when rates fell, and they tended to underperform as rates rose, so these indexes are sensitive to changing interest rates and that's a risk that is not apparent, just from hearing the name "low volatility." You don't assume that there is any connection to interest-rate sensitivity, but in fact the data suggest that this is a pretty significant effect. And it's one that really hasn't been a lot of people's radars because rates have been so low for so long …

Benz: That's right, yeah.

Bryan: … that a lot of people haven't really given it much thought.

Benz: Right. And certainly people are thinking about it going forward, though, I think that there are concerns that rates, while there may not be a huge move up anytime soon, but that's obviously going to be--well, not obviously but it could be the long-term direction for interest rates. So let's talk about what about these low-volatility strategies tends to make them susceptible to rising-rate environments.

Bryan: Sure. So, I think probably the best way of thinking about this is to understand that rates don't change in a vacuum, right, so you have to understand what's going on when rates rise or when they fall. So typically the Federal Reserve will increase rates as the economy strengthens, so that means that businesses are tending to do a bit better, consumers are feeling more confident. This is a period of growth, economic expansion.

In those environments, more cyclical stocks, stocks that are a bit more volatile and that move around more with the market, they tend to have more growth, and that allows them to offset the negative impact of rising rates.

Now low-volatility stocks on the other hand are a bit more defensive, so these are typically your consumer-staples companies, your utility companies--they don't have that same cash flow growth in an expanding market environment as their more cyclical counterparts. So they have less growth to offset the negative impact of rising rates. As a result, they will tend to underperform in those environments.

So, it isn't necessarily that the rates are the causal effect here. It's about that context of what's going on. If you are a more stable bondlike stock, you are going to have less growth to offset the negative impact of rising rates when they do go up.

Now on the flip side of that, in a weaker market environment when rates tend to go down because the Fed is trying to stimulate the economy, that's when a more defensive type of stock will do well and that's when you would expect it to do well, like in 2008-2009. So more defensive stocks will have less contraction in their earnings, so they can actually get more of the benefit from the lower rates whereas their more cyclical counterparts will have a more of a negative impact from the weakening economy.

Benz: Are dividends in the mix here, too? Do you think that they are perhaps intertwined with all of this? Do some of the low-volatility stocks also have fairly decent dividends to match?

Bryan: Some of them do. These are not necessarily the same as the high-dividend strategies out there, but yes, that could be a component of it. But if you think about the types of companies that do pay high dividends, those tend to be more mature, stable companies anyway, so I think the explanation as to why low-volatility stocks do well in a falling-rate environment and poorly in a rising-rate environment could also carry forward to explain the behavior of high-dividend-paying stocks, and I have found similar interest-rate sensitivity for high-dividend-paying stocks.

Benz: So, fund providers, ETF providers are aware of this issue. In fact, there are new products that have come to market that actively control for this rate sensitivity. Let's talk about that. It seems like some of these products are pretty finely sliced, but let's talk about that product category.

Bryan: Sure, so there is actually only one fund out there that explicitly tries to control for this interest-rate sensitivity, and that's the PowerShares S&P 500 ex-Rate Sensitive Low Volatility ETF, which is a mouthful. Ticker is XRLV. What this fund does is it starts with the same universe as the other PowerShares fund I talked about, but it tries to screen out the 100 most interest-rate sensitive stocks from the S&P 500 before it goes to that ranking process to target the stocks with the least volatility.

So, it's first filtering out the most interest-rate sensitive stocks, then it's trying to target the least-volatile stocks with the remaining universe. What that creates is a portfolio that tends to have fewer utilities as you might expect, because utilities, you know a lot of their expenses are interest-rate payments, so when interest rates go up, utilities tends to do poorly. So, that's the most notable difference between the two portfolios.

But by and large, you get a similar type of portfolio that still tends to skew toward the more defensive names. This particular fund has been less volatile than the broad market, so it's still meeting its objective, and it has been a little bit less sensitive to fluctuating interest rates than the regular PowerShares S&P 500 Low Vol fund.

That being said, it still is a bit sensitive to rising interest rates, so it's not a silver bullet. And it only looks back at interest-rate sensitivity over the past five years, meaning it may not fully capture how stocks will perform in different interest-rate environments, but it's an incremental improvement if you are worried about rising interest rates.

Benz: OK. So what's the takeaway for investors? I know that there have been pretty strong asset inflows into this group over the past several years. Should investors steer clear of low-volatility funds? How should they use this information?

Bryan: I think it's important to set the right expectations up-front. So, if you are concerned about rising interest rates, then I think that you should go into a low-volatility strategy if it is in fact what you want to do, with the understanding that these stocks may be disproportionately affected by rising rates, compared to the broader market.

But that being said, I think that's a risk that comes with the territory, and I think that investors who are still drawn to the attractive risk-adjusted performance that these strategies can offer should stick with it over the long term, because even despite this interest-rate sensitivity, I think there is a reasonable expectation that low-vol strategies will continue to offer attractive performance characteristics over the very long term.

And if you are risk-averse investor, these strategies may help you stick with stock investing whereas the broader market may be a little bit more challenging. So, I think for lot of people there is still pretty strong merit behind these strategies. So, I would stick with it, but be sure you have the right expectations. Don't expect these things to outperform in a rising-rate environment.

Benz: OK, Alex. Thank you so much. Really interesting research. Thank you for being here to share it with us.

Bryan: Thank you for having me.

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