High-risk, high-return equities have been on a hot streak, outpacing the big, boring dividend payers in the current market rally. However, looking at risk-adjusted returns, low-volatility stock exchange traded funds could outperform in the long run.
“In nearly every market studied, low-volatility stocks have greatly outperformed high-volatility stocks on a risk-adjusted basis, a finding at odds with many investors’ notions of risk and return,” writes ETF strategist Samuel Lee for Morningstar.
Lee explains that there are three reasons why low volatile stocks have historically outperformed: leverage aversion – investors don’t want to use volatile stocks to hit their expected-return targets; high-volatility stocks are overpriced by investors seeking “lottery tickets” to win it big; asset managers steer toward high-volatility stocks with poor risk-adjusted returns. [Low-Volatility ETF Cools as ‘Junk’ Stocks Soar]
While most analysts point to the S&P 500’s cheap 15 forward price-to-earnings ratio or a forward earnings yield just under 7%, these values are based on the short-term. In utilizing the Shiller P/E, which averages real earnings over 10 years, a 1,600 S&P 500 equates to a Shiller P/E of 23, or 40% higher than its historical average.
Next page: Core holdings
Consequently, Lee argues that the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) is a good fit as a core equity allocation since it “can be expected to be about a third less volatile than the broad market.” However, due to their tilt toward conservative picks, low volatility stocks will underperform during short-term bull rallies. [Low-Volatility vs. High-Beta ETFs: New Secular Bull Market?]
USMV’s low-volatility portfolio keeps stock weights between 0.05% to 1.5% of the portfolio, sector weightings within 5% of the market-weighted index and a one-way turnover of 10%. The ETF has a 0.15% expense ratio.
Alternatively, investors can consider the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which weight the 100 least-volatile S&P 500 stocks by the inverse of their volatility – the least volatile stocks have a heavier weighting. SPLV has a 0.25% expense ratio.
Moreover, investors can find low-volatility international exposure with the PowerShares S&P Emerging Markets Low-Volatility Portfolio (NYSEArca: EELV) and the PowerShares S&P International Developed Low Volatility Portfolio (NYSEArca: IDLV). EELV has a 0.29% expense ratio and IDLV has a 0.25% expense ratio.
The iShares MSCI EAFE Minimum Volatility ETF (NYSEArca: EFAV) and iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV), which come with an expense ratios of 0.20% and 0.25%, respectively, utilize the more complex “minimum variance” methodology in determining low volatility stocks. Additionally, investors can take a look at the all encompassing iShares MSCI All Country World Minimum Volatility (ACWV), which has a 0.34% expense ratio.
For more information on the low-volatility strategy, visit our low-volatility category.
Max Chen contributed to this article.