Recent stock market volatility has generated a new interest in adding low-volatility funds to peoples’ portfolios.
The idea of low-volatility investing has been around for years, but it gained momentum during the 2008/09 financial crisis. With some investors worried about stock market gains reversing or how geopolitics might impact their portfolios, and others just wanting to be prudent investors, low-volatility funds could continue to see considerable growth.
Let’s explore the various types of low-volatility funds, and whether they’re worth considering.
What are low-volatility funds?
Low-volatility funds give exposure to a designated market in such a way as to experience less volatility than the overall market: a smoother ride is their primary objective. In practice, these funds are expected to lag the market slightly when times are good and offer better downside protection when markets fall.
In exchange for giving up a little in expected returns when the markets go up, these funds tend to deliver fewer and less wildly unpredictable swings in value. Over the long term, this can translate into better risk-adjusted returns (higher returns for the risk taken), which makes these funds attractive to risk-averse investors.
Why would you consider a low-volatility fund?
While downside protection is the most obvious reason to look at low-volatility products, there are other advantages worth considering:
1) A smoother ride - many investors who prefer to avoid extreme market movements use low-volatility funds.
2) A toe in the water - For risk-averse investors, low-volatility funds can provide a less stressful entry point to equity investing.
3) Confidence to stay invested - Investing in low-volatility funds can give investors more confidence to stay true to their “buy-and-hold” intentions. It can prevent them from reacting during downturns and exiting the market at the worst possible time.
4) Shorter recovery time - Sometimes the equity market can take a considerable time to recover from sharp sell-offs. Some investors, such as those nearing or in retirement, can’t afford to wait out an extended downturn.
Are all low-volatility funds the same?
Low-volatility funds can follow a wide range of strategies, from plain-vanilla large cap equity funds to alternative strategy funds, and everything in between. Within each of the approaches described below, a variety of strategies may be used:
1) Portfolios of low-volatility stocks - One of the simplest techniques is to build a portfolio of stocks that typically have less-than-average volatility. Some low-volatility U.S. ETFs, for example, simply hold the 100 stocks in the S&P 500 that had the lowest daily volatility over the past year. Some Canadian low-volatility ETFs are based on the S&P/TSX Composite Low Volatility Index, which selects the 50 least-volatile stocks from the TSX index.
2) Stocks with low correlations - Another popular approach is based on the correlation between individual stocks (the degree that stocks tend to move up or down in sync with each other). Stocks that are uncorrelated (which move differently from each other), can balance each other out. This approach may be more effective at reducing overall portfolio volatility than stocks that may be less volatile but more highly correlated (which all move in the same direction).
3) More sophisticated approaches - Some low-volatility strategies develop proprietary risk models that attempt to incorporate other sources of risk exposures (such as excessively high valuations). The aim is to make these portfolios more adaptive to changing market environments and thus reduce risk more effectively. They can incorporate factors such as valuation, quality (for example, earnings stability) and momentum, to minimize the risk of exposure to low-volatility companies that have become dangerously expensive. Some funds also employ derivative strategies or other complex hedging tools to further limit volatility.
What are the potential risks and challenges?
As low-volatility strategies become popular with risk-averse investors, it’s important to acknowledge that low volatility does not mean risk free. In pursuing a less bumpy ride, these strategies can expose investors to other risks including but not limited to:
1) Reliance on past risk data - There’s no guarantee that stocks displaying the least volatility historically will continue to do so in the future. Companies do change, so reliance on past risk data, such as historic volatility, may lead to unexpected results.
2) Underperformance in rising markets - Low-volatility funds are designed to dampen movements both to the downside and to the upside, compared to traditional funds. Therefore, in extended up markets, low-volatility strategies may miss out on significant gains.
3) Concentration - Some funds that focus only on historical volatility can have a dangerous over-concentration in certain defensive sectors, such as consumer staples, health care or utilities, or overexposure to risk factors such as interest rate sensitivity.
4) Turnover - Depending on the frequency of rebalancing and sensitivity of optimizing models, some low-volatility funds could experience high turnover rates. The trading costs and tax liabilities could be an issue for funds held in non-tax-sheltered accounts.
5) Valuation - As with any niche investment strategy, a surge in popularity can worsen its future prospects. Too much money chasing a subset of the market with such a small base will drive up valuations and lower expected returns. Incorporating valuation into their risk models may help some low-volatility strategies mitigate this risk.
6) Outflows - When valuations become stretched, low-volatility funds may experience pronounced outflows if the market conditions that drove their popularity become more uncertain. As with any strategy focused on a narrow market subset, large outflows will have a negative impact on prices, and investors could suffer losses if there is a scramble to get out.
Is a low-volatility fund appropriate for you?
Low-volatility funds provide several potential benefits: a smoother ride, a way to cautiously enter the markets, encouraging the discipline to stay invested, income possibilities and the chance for higher risk-adjusted returns.
However, even if the potential risks are deemed acceptable, a low-volatility strategy may not be appropriate for everyone. These funds are designed to be held for several years. If you’re committed to a long-term investment period, then you need to decide whether it’s the right choice to potentially sacrifice long-term performance to avoid the daily or weekly ups and downs.
There are also several ways to reduce volatility beyond holding low-volatility investments. These include diversifying your holdings with uncorrelated assets and investing in asset allocation products, which are designed to deliver a similarly smooth ride.
But if the stock market rollercoaster keeps you up at night, a low-volatility strategy could give you the peace of mind and confidence to stay invested over the long term. Talk to a Certified Financial Planner (CFP) professional to discuss the portfolio that best reflects your concerns.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.