The low volatility phenomenon is described as an anomaly; like ball lightning or a dog that says “sausages” or sexy popes, it shouldn’t work but it seemingly does.

The promise of low volatility equities is three-fold:

• Returns that match or exceed the market over time…

• …while inflicting around 20% less price fluctuation pain upon investors, and…

• …during a bear market nightmare, total losses that are less severe than the market as a whole.

It sounds too good to be true. The same or better returns for less risk? Yes please, I’ll have some of that.

Most investors will be aware that financial theory warns that you don’t get something for nothing. There’s no reward without risk they say, and so more volatile investments should offer greater expected returns than safer options. Except they don’t.

Low volatility equities have been shown to outperform their high vol peers, offering superior risk-adjusted returns over the course of the last 40 years.

And that’s as weird as a catfish playing with yarn. What are we doing stocking our portfolios full of shares that are about as stable as dynamite when we could get the same results for much less trouble?

The low down

Low volatility is another of the return premiums that concentrate on certain company traits to produce something like a genetically modified super-crop of equities – with the potential to increase the return of your portfolio.

In this case, the low volatility bracket is filled with companies that are relatively less affected by the movements of the broader stock market.

These are known as low beta companies. When the stock market takes a tumble, their prices won’t necessarily fall so far in tandem.

An example of a low beta equity is a power company. Customers still need to keep the lights on even during a recession, so the firm and its share price may be less badly hit than say a car manufacturer when the wider economy heads south.

Equally, if there’s a raging bull market, the utility firm will benefit from the general upswing in demand. But it’s unlikely to get as big a bounce as the car company with its new line of robot-chauffeured roadsters.

The upshot is that low volatility strategies tend to underperform during the good times and outperform during the bad.

Humans don’t learn

None of this explains why sluggish shares should out-perform high beta (that is, high volatility) shares that experience more ups and downs than an elevator operator.

For that it seems we must once again turn to our dumb human brains.

There are a number of theories from behavioural finance that might explain why we accept higher prices and lower returns when buying high volatility equities:

• We love a lottery. We’d sooner gamble on an overpriced tech company that’s never made a bean in the hope that it might become the next Google than we would invest in some boring dog food cannery that will keep making profits as long as people don’t want to starve their dogs.

• Overconfidence means we’re convinced we can pick the next Google out of the crowd, even though we know most investors don’t have this skill and most ‘next Googles’ turn into the last GeoCities.

• Optimistic analyst forecasts for fast-growing equities serve to push up prices and consequently lower future returns.

• Active fund managers dare not tilt towards low volatility equities for fear that they’ll get fired when they deviate from their benchmark for a prolonged period.

• We’re not all Sages of Omaha. One way to exploit the low volatility anomaly is to load up on less risky equities and then pump your returns with leverage. ++ Alert ++ Alert ++ Compulsory Warren Buffet reference: Warren Buffet apparently does this with his insurance company float. ++ End Alert ++ But many investors are prone to leverage aversion. They’re either not allowed (pension funds) or too afraid (me!) to take on the risks, costs, and hassle of borrowing to invest. So instead they lean on high beta assets for extra snap, crackle, and pop but that dependency raises prices and reduces future returns.

A low ebb

Human behaviour being what it is (i.e. mentally frozen in the Paleolithic), there’s good reason to believe that low volatility may survive the ravages of arbitrage as has momentum.

For instance despite the anomaly’s discovery in 1972, low volatility beat the US market by 2% per year between 1963 and 2009, while exhibiting 15% less risk.

However, like all the return premiums, low volatility is not an escalator to dreamland. There’s no guarantee it will outperform in the future and there’s a near certainty that it will underperform for years at some point – testing your will and sanity when it does so.

Indeed, the irony of low volatility’s recent popularity (and the proliferation of supporting tracker products) is that low vol equities may have become significantly overvalued.

As always, when an investing strategy becomes a fad, then there’s a heightened danger that it’s due a strong dose of underperformance. That plus a few other controversies surrounding low volatility are worthy of further consideration.

Take it steady,

The Accumulator

Good reads from around the Web.

Finally, a bit of volatility in the markets after all that tedious upward marching, and we are reminded why equities are about risk as well reward.

As blogger Josh Brown put it in the midst of the volatility:

At least the 10%-ish correction has given pundits a chance to dust down their brace position mantras. I’ve selected a few below.

Most are aimed at active investors. There are rarely enough passive articles for me to squander any here – but you can find some relevant links in the Passive sections as usual.

That said, much of this stuff is behavioural, and it applies to everyone.

My advice to true passive investors would be to stick to your allocations, and ignore the movements until you come to your next scheduled rebalance.

(Oh, and remember when people were asking The Accumulator why he held around 40% in government bonds in his model portfolio, and how could he be satisfied with that supposedly dreary 6% annualized gain? This is a reminder.)

Some thoughts on the falling market

The market falls mean UK shares look pretty cheap by the CAPE measure, reports ThisIsMoney:

The current UK market CAPE ratio stands at 14 for what is broadly the equivalent of the FTSE All-Share using the data from Thomson Datastream.

That compares favourably to a long-run average of 19.6, although it stands someway above the 11.4 it hit at the bottom of the market slump in 2009.

..and UK Value Investor uses the same yardstick to question how much further the FTSE 100 could credibly drop:

At 5,000 the FTSE 100’s CAPE would be 10.

If it fell to 4,000 then its CAPE would be 8 and at 3,500 its CAPE would be 7.

To give you something to compare those numbers to, in 2009, when the FTSE 100 stood at 3,500 and everybody thought the financial world was about to end, the market’s CAPE was 9.5.

So assuming the CAPE approach is correct, for the FTSE 100 to reach 5,000 investors would need to be as pessimistic as they were when we were days, or even hours, from a global financial collapse.

Currently that seems a little unlikely.

Remember that that the “E” in CAPE can fall as well as the “P” – i.e. earnings would probably fall in a big global slowdown – although CAPE does smooth this out to some extent.

But for now the world is hardly ending, reports Alan Roth at AARP:

Stick to an asset allocation you can live with. Decide what proportion of your portfolio should be in stocks and stick to it, irrespective of the headlines.

The implications are simple: You have to buy stocks when they plunge and sell when they surge.

Simple? Yes. Easy? No.

The Eight at Eight blog has some less pithy and more poetic advice that might be worth reading if you’re young and not used to volatility:

Surviving isn’t a frozen moment in time, but is in fact a continuous effort to maintain equilibrium in your mindset and in your investment approach no matter what the market conditions are. A constant reminding to yourself of the end goal as an investor. A retaining of beliefs in yourself, your methods and investment decisions.

While the similarly colourful Wexboy begins his wide-ranging recap by pointing out how trivially we shout “Fire!” nowadays:

Traditionally, a 10% market reversal was defined as a correction, while a bear market was at least a 20% decline.

But now the business media’s upped the ante, unilaterally adopting something like 3% & 10% as the new thresholds

Perhaps that’s why Patrick O’Shaughnessy at Millenial Invest is already having flashbacks from the last war:

Markets are, at their core, about emotions and how you handle them.

It is so easy to be brave from a safe distance, to say that you will be cool when the tough times come.

During 2008-09, I learned that that is naïve bullsh*t.

Those were terrifying times. I was worried to my core about my family’s future, the business, and all of our clients who had trusted us with their money.  I convinced some to stay the course, but failed more often than I succeeded.

But the truth is we’re a long way from 2008 today. We’re not even in 2012 territory.

I enjoyed these articles, but I do think the sheer volume of words – of which the articles above are just a smidgeon – in response to what’s been a modest if swift correction so far tells us more about how gentle things have been than anything much about the future.

[continue reading…]

The videos we’ve been featuring every week on Monevator from Sensible Investing TV have done a sterling job of reminding us why passive investing via index funds is the best bet for most people.

Index investing makes sense mathematically – because active investing is a zero sum game – and also because the vast majority of active funds fail to beat the market over the long-term, not least because their higher costs turn that zero sum game into a markedly losing one.

Even Warren Buffett – one of the greatest stock pickers of all-time – says you should probably use index funds.

But most people don’t, perhaps because:

• They’re not aware the theory and evidence favours index funds.

• They want to try to beat the market anyway.

• They find active investing more enjoyable, despite the downsides.

• Passive investing just feels wrong.

Does that sound like you? This video has a few tips on what you might consider if you’re determined to invest in active funds:

A few things to consider with active funds

It would take multiple articles to really dig into investing in active funds – and to be honest I’d probably outsource writing them to somebody keener – but I will share a few thoughts.

The first thing I’d say is that unlike some of the more extreme passive investing propagandists, I don’t think investing in active funds is a nailed-on road to ruin.

You can invest steadily in a portfolio of active funds for the long-term, and end up with a good result. Yes, very likely not as good as if you used index funds due to active funds’ higher fees, but that’s what the other videos in this series have been about so we won’t repeat it here.

Investing in active funds is at least a bit cheaper than it was now initial fees have been scrapped. Note though that some pundits believe annual costs have actually increased, albeit in a sneakier fashion.

And costs as always matter when investing.

Many of those who tout active funds – particularly expensive hedge funds – say that once you go active you shouldn’t be concerned about costs but simply performance, but that isn’t true at all.

The same remorseless maths that makes trackers the optimal choice also helps lower cost active managers in their quest to beat the market. So I’d avoid any expensive funds, especially those with performance fees.

I’d also avoid most new funds, fad funds, closet trackers, and investing in anything you don’t understand.

What have you done for me lately

What about past performance? Should you pick a past winner?

This is a thorny subject. On the one hand, as Oblivious Investor put it in his overview of research into this area:

“…picking funds based on superior past performance proved to be less successful than picking randomly.”

That’s hugely counter-intuitive, but many things about investing are.

I’d be lying though if I claimed that I wouldn’t check out past performance if I was looking into an active fund (and I have done previously where I’ve bought, say, closed-end funds). Hey, I’m only human.

And also, you know, Warren Buffett…

Still any such peek would only be one part of my wider research into a fund’s strategy, its positioning, what risks it’s taking for its returns, and so on.

As discussed below, I would explicitly not be looking for a strong recent performer and piling in!

Income investment trusts

I’ve previously admitted to a soft spot for investment trusts – ideally bought on a discount – and in particular I think well-established UK equity income trusts are a good option for private investors who want to pursue an active route.

Make sure you understand how discounts and premiums work if you do invest in them, and be sure you’re bedding in for the long haul.

One reason I like income investment trusts is that there are quite a few established funds out there.

Also their mandate to deliver a growing income focuses the manager’s minds, and keeps them largely sticking to the knitting. This is important because a consistent management style is one of the most important factors in an active fund.

In contrast if you buy into a flighty fund manager, you’re in danger of investing in one who shifts style at the wrong time to chase performance, reducing the fund’s returns.

Of course theoretically a very skilled manager might shift style at the right time.

But I wouldn’t fancy your odds of finding one.

Mind the behaviour gap

On that last note, remember that investors can be their own worst enemies.

They chase performance and dump funds at the wrong time, which means they don’t even enjoy what gains active investing might deliver them. (Yet another reason why the strategy of passively rebalancing is such a potent concept).

Blogger Ben Carlson recently showed how poorly an average investor in the highly-regarded but also highly-volatile US Fairholme Fund had done, compared to the returns posted.

This graphic gives a summary:

The table shows that over 10 years the Fairholme Fund delivered 10% in annualized returns, but the typical investor actually achieved around 5%.

Investors’ attempts at timing in and sell out of the fund halved their returns.

I believe this sort of thing is more likely to happen when you invest in active funds, because you’re inevitably going to be thinking a lot more about whether your manager has still ‘got it’ when they go through a tough spot, and so on.

In contrast, a good index fund investor accepts they know nothing, and instead just invests passively and rebalances occasionally, which reduces the risk of performance chasing.

Still, despite their strategy many passive investors do suffer from these behavioural problems too, and so they’re not an automatic strike against active fund investing. (We’ve got enough of those to be going on with, anyway!)

If you want a few more thoughts on pursuing an active fund strategy, please see my commentary after the third video in the series.

Check out the rest of the videos in this series so far.