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How to invest in the low volatility premium

When an investing concept is designed to appeal to your emotion, tread carefully. We all want security and nourishment and that’s precisely the draw of the low volatility – market-beating returns with less risk than yer average clutch of ticking time-bomb equities.

There are known problems with low volatility, but if you still want a slice of this action then what do you need to know?

The two faces of low volatility

Below you’ll find a handy list of the low volatility Exchange Traded Funds (ETFs) available to UK investors.

But before we get into it, you should know that – like the other return premiums – there’s more than one way to skin the low volatility cat.

In most cases, a low vol ETF will track an index that falls into one of two broad categories:

  • Low volatility index: Ranks the equities of its parent index according to their return volatility over the last 12 months or 24 months or whatever timeframe the rules dictate. Lower volatility equities are over-weighted in the index and higher volatility members are under-weighted.
  • Minimum variance index: Also weights equities according to their historical volatility, but then analyses the correlations between the equities in order to reduce volatility at the portfolio level.

Which is best? Well, according to the paper A Study of Low Volatility Portfolio Construction Methods from Research Affiliates:

We find no evidence that one low volatility portfolio construction methodology stands out from a returns perspective.

Okay, that makes things  easier – but it doesn’t mean you should just pick any ETF out of a hat.

Low volatility strategies are broadly similar

So how do they differ?

All low volatility ETFs are known to skew towards defensive sectors of the economy, such as healthcare and utilities.

However minimum variance strategies typically impose greater constraints on the concentrations of individual equities, sectors and countries within the index. For example, MSCI rules that sector weights must remain within 5% of the weights in the parent index.

By contrast ‘naive’ low volatility strategies generally do not cap constituents. This means they can become highly concentrated in the healthcare and utility sectors at times. Similarly Japan will often loom large in World ETFs that follow low volatility strategies.

The Research Affiliates paper found the minimum variance approach is likely to be:

  • More diversified.
  • More costly, due to higher turnover.
  • More effective at reducing volatility where the index tracks dissimilar markets, such as emerging markets.

While there wasn’t much in it, the authors tentatively concluded:

While [minimum variance] portfolios generally have the lower volatility, heuristic approaches [naive low volatility] tend to have the higher long-term returns. (We caution against comparing low volatility strategies on the basis of short-term performance.) The resulting Sharpe ratios are statistically similar.

The historical record of low volatility shows that it’s generally beaten the market during declines and taken a beating during upswings.

This means your blackest periods of doubt are likely to come during extended bull runs when the low volatility slice of your portfolio is lagging the herd like a lame elephant.

You’ll have to resist the temptation to abandon it at its lowest ebb if it’s ever to come good for you.

What should I look for?

While the research concludes that there is little to choose between the various strategies, you should know what matters to you as an investor.

  • If you don’t like concentrated bets then err towards minimum variance.
  • If return is all that counts then naive low volatility may be the way to go.

Of course, there aren’t any guarantees – fate does not give us advance notice of its plans. But at least you’ll know you’ve put out the welcome mat.

And such good value, too

It’s thought that low volatility outperforms partly because it overlaps with the value premium. So you could compare the value signal strength of your target low vol ETFs using Morningstar’s Fund Compare tool.

Jump to the equity valuation section and look for the lowest numbers in the following categories:

  • Price/Prospective Earnings
  • Price/Cash Flow
  • Price/Book

You can compare sector and country concentrations using Fund Compare, too, although past returns will be of little use because low volatility ETFs are still very young.

Check out the ETF’s factsheet for important info such as how many holdings it has (the more the better) and make sure you read up about the index on the index provider’s site, so you broadly understand how it works.

A low volatility ETF hitlist for UK passive investors

Here’s the low volatility range currently available, organised by asset class:

Global Low Volatility ETFs1 Index strategy OCF2
iShares MSCI World Minimum Volatility Minimum variance 0.3%
Ossiam World Minimum Variance Minimum variance 0.65%
Lyxor MSCI World Risk Weighted Minimum variance 0.45%
db X-trackers Equity Low Beta Factor Low volatility 0.25%

Source: Author’s research.

UK Low Volatility ETF Index strategy OCF
Ossiam FTSE 100 Minimum Variance Minimum variance 0.45%

Source: Author’s research.

US Low Volatility ETFs Index strategy OCF
iShares S&P 500 Minimum Volatility Minimum variance 0.2%
Ossiam US Minimum Variance Minimum variance 0.65%
SPDR S&P 500 Low Volatility Low volatility 0.35%

Source: Author’s research.

European Low Volatility ETFs Index strategy OCF
iShares MSCI Europe Minimum Volatility Minimum variance 0.25%
Ossiam iSTOXX Europe Minimum Variance Minimum variance 0.65%
SPDR Euro STOXX Low Volatility Low volatility 0.3%

Source: Author’s research.

Emerging Markets Low Volatility ETFs Index strategy OCF
iShares MSCI Emerging Markets
Minimum Volatility
Minimum variance 0.4%
Ossiam Emerging Markets
Minimum Variance
Minimum variance 0.75%

Source: Author’s research.

Low volatility in your portfolio

Regardless of the comfy name, low volatility ETFs are equity products and they will still take a hit during a market tumble. If you decide to use them in your portfolio, the money should come out of the equity portion of your asset allocation.

If you think you’re likely to regret a long period of market lagging performance – and few of us wouldn’t – then I’d suggest you limit your low volatility bet to a 5-15% slice of your equity allocation.

Take it steady,

The Accumulator

  1. Note: Global usually means developed world. []
  2. Or TER. Learn more about the difference []
{ 4 comments… add one }
  • 1 Rob November 4, 2014, 4:21 pm

    Volatility is not a fundamental feature of a company’s financials. It is partly a function of the industry, house builders will be more volatile than retailers, and gearing. More debt makes the company more sensitive to any change in business conditions.
    But companies change. Tesco was undoubtedly a low vol share, until it wasn’t when they discovered the financials weren’t quite, well accurate. A bit like their lasagne labels.
    An alternative approach is simply to look at existing funds and select those with the lowest betas and highest yields. Boring share tend to have higher yields than exciting and volatile ones.

  • 2 dearieme November 5, 2014, 12:24 pm

    “defensive sectors of the economy, such as healthcare and utilities”: but how defensive would these be in the UK, given the prospect of a Labour government? On the other hand, if a Labour government were to return to rent controls, maybe a lot of money would flow from BTLs to equities.

  • 3 Uncertain November 5, 2014, 2:58 pm

    There is an article in todays FT by John Authers basicallysuggesting that this phenomenen is due to Fund managers benchmarking against Indices. (Risk-return relationship has been upended)
    He also suggests it leads to inefficient allocation of resources so anyone taking advantage of this phenomenen may be doing dsociety good.

  • 4 The Accumulator November 8, 2014, 6:43 pm

    @ Uncertain – yep, that’s one of the theories. It’s likely to be a cocktail of factors including fear of leverage, the human bias for lottery ticket type equities, over-optimism about growth firms and more: http://monevator.com/low-volatility-premium/

    The problem with taking advantage of it is that a lot of investors have already done just that, so there’s evidence to suggest that low vol is overvalued and perhaps not such a good bet in the future: http://monevator.com/low-volatility-problems/

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