Don't Get Lured Into Low-Volatility Strategies

2013-05-30

by: Eric D. Nelson, CFA

One of the most popular new investment strategies is called “low-volatility” investing.  Academic research has found that stocks with the lowest levels of fluctuation, or volatility, tend to outperform stocks with the highest volatility.  Never wanting to miss an opportunity to develop and market a new product to generate add fees, Wall Street firms have been quick to come to market with mutual funds and ETFs that cover all types of low-volatility stocks.  The largest fund, the Powershares S&P Low-Volatility ETF, has attracted a whopping $5B in assets despite only two years of operation.

 

So where’s the problem?  Well, what much of the research conveniently ignores is that low-volatility stocks tend to have different risks that don’t always show up in simple measures of price fluctuation.  First, low-volatility stocks tend to be “value-oriented” companies with low price/earnings or price/book values—and we know these firms can often turn in worse-than-market returns during the most severe financial crises.  Second, low-volatility portfolios have extreme sector biases.  Utilities, for example, often comprise 25% to 35% of low-volatility portfolios, which represents an extreme bet relative to a more diversified portfolio.  Finally, thanks in part to the large utility exposure, low-volatility strategies have considerable exposure to interest rate changes.  

 

This last point helps to explain why low-volatility strategies have done so well in research simulations when compared to the overall market.  Interest rates peaked at about 15% in the early 1980s, and have fallen to under 2% today.  This decline in interest rates allowed for a massive headwind for bonds (as rates fall, bond prices rise) as well as stocks with interest rate sensitivity.  Had interest rates instead risen over this period, it is unlikely that anyone would be interested in low-volatility stocks because their returns would have been far below traditional stock indexes.

 

Evidence of this interest rate sensitivity and risk can be seen in just the last month, as rates have risen significantly and both bonds and low-volatility stocks have performed very poorly compared to traditional stock asset classes.

 

Table 1: One Month Returns Through 5/29

Portfolio

% Return

DFA US Large Growth Fund (DUSLX)

+3.8%

DFA US Large Value Fund (DFLVX)

+5.4%

DFA US Small Growth Fund (DSCGX)

+5.8%

DFA US Small Value Fund (DFSVX)

+6.2%

Powershares S&P Low Volatility ETF (SPLV)

-2.3%

Vanguard Long-Term Fund (VUSTX) 

-5.8%

source: Morningstar.com

 

Shown in Table 1, the Vanguard Long-Term Treasury Fund has lost almost 6% in the past month, a very large move for bonds in such a short period of time.  And despite very strong returns for traditional stock asset classes—4% to 6% for large and small growth and value stocks—low-volatility stocks were significantly impacted by rising rates and also lost value, falling over 2%.

 

Unfortunately, many investors who have piled into low-volatility strategies with the hopes of outperforming the market with less risk may be unpleasantly surprised if this interest rate trend continues.  Persistently higher rates could lead to losses on longer-term bonds and low-volatility stock strategies at the same time, nullifying any diversification benefit presumed to exist between stocks and bonds.

 

The alternative for investors looking for acceptable risk and return is to first diversify their equity portfolios across large and small, growth and value stocks globally, then dilute with a low-risk fixed income fund in the amount that their appreciation goals and risk tolerance calls for.  On an ongoing basis, differences in returns between stocks and bonds as well as different stock asset classes will result, allowing for the additional benefit of a “diversification return” through disciplined rebalancing back to portfolio targets.  Bundling stock and bond behavior in one portfolio, as low-volatility strategies basically do, is likely to produce lower returns and higher/hidden risks.  And for those who don’t understand what they own, low-volatility strategies could be a recipe for serious disappointment.  Don’t get lured into low-volatility strategies.

 

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Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Clients’ investment returns would be reduced by the advisory fees and other expenses they would incur in the management of their accounts. Indexes are not available for direct investment.