With the equities markets experiencing one of their worst stumbles in years, exchange traded fund investors may turn to low-volatility strategies that could help hedge the risks and diminish a portfolio’s swings.
“Low volatility is one of the few factors that have historically performed well in turbulent markets,” according to a MSCI research note, Constructing Low Volatility Strategies. “Moreover, over long periods of time, this defensive strategy has produced a premium over the market, contravening one of the most basic theories in finance — that one should not be rewarded with greater returns for taking less than market risk.”
Extensive research has gone over the so-called low-volatility anomaly. As a more conservative strategy, low-volatility investments are expected to provide investors with smaller swings and more boring returns. However, the strategy has historically outperformed with higher risk-adjusted returns.
“Mostly behavioral arguments have been offered to explain the low volatility premium,” MSCI said.
Behavioral characteristics include the lottery effect where investors bet on a win in high volatile stocks; representativeness or the tendency to overpay for “glamorous” high volatility stocks; overconfidence in one’s ability to forecast the future; agency issue where people tend to eschew low-vol stocks due to less research; and asymmetric behaviors where low-vol stocks show smaller swings in both down and up markets.
MSCI utilizes a sort of optimized-based method, which accounts for volatility and correlation effects, as opposed to simpler methods that rank components based on levels of volatility.
“Optimization-based approaches provide a more flexible framework to incorporate different types of constraints,” MSCI said. “Moreover, only optimization-based approaches can take full advantage of the correlation between stocks, a key component in designing a low volatility strategy.”
For those interested in low-volatility strategies, there are a number of ETFs available that track more steady segments of the markets. For instance, the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) selects stocks based on variances and correlations, along with other risk factors. The competing PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) tracks the 100 least volatile stocks on the S&P 500.
The low-vol ETF strategy has also been outperforming, or at least they have not retreated as much as the broader market. Year-to-date, SPLV dipped 1.5% and USMV fell 1.0% while the S&P 500 declined 5.0%.
Investors can also target European market exposure through the iShares MSCI Europe Minimum Volatility ETF (NYSEArca: EUMV). Additionally, the relatively new PowerShares Europe Currency Hedged Low Volatility Portfolio (NYSEArca: FXEU) hedges against currency risks as well as targeting 80 of the least volatile stocks taken from the S&P Eurozone BMI Index.
ETF investors can also take the low volatility theme to broader overseas markets. The low-volatility ETFs have helped soften the blow from the global sell-off. For example, the the PowerShares S&P International Developed Low Volatility Portfolio (NYSEArca: IDLV) and iShares MSCI EAFE Minimum Volatility ETF (NYSEArca: EFAV) provide a low-volatile option for developed overseas markets.
Additionally, investors can target emerging market exposure through the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV) and PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEArca: EELV).
However, potential investors should be aware that since these ETFs focus more more slow and stable companies, the low volatility strategy may underperform more growth-oriented stocks if the markets turn around.
Max Chen contributed to this article.