After enjoying a multi-year bull run, equities may be in for greater volatility ahead. Nevertheless, exchange traded fund (ETF) investors can still keep their toe in stock market but hedge against large drawdowns through a low-volatility strategy as a way to potentially generate steadier returns over the long run.
While not as glamorous as high-flying growth strategies, a low- or minimum-volatility portfolio has helped generate better long-term, risk-adjusted returns.
The low-vol strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy focuses on equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are comprised of stocks that exhibit lower market risk or beta.
Extensive research has gone over the so-called low-volatility anomaly of outperformance. As a more conservative strategy, low-volatility investments are expected to provide investors with smaller swings and boring returns. However, the strategy has historically outperformed with higher risk-adjusted returns.
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Market observers have attributed the outperformance to structural impediments and a behavioral bias. Specifically, structural impediments, or rules and restrictions that may make some investments off limits to certain investors, have fueled a preference toward high-flying stocks in hopes of higher returns.
Additionally, 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.
Whatever the case may be, the low-vol strategy has helped investors gain greater exposure to more conservative stocks that have held up during volatile market swings. For instance, the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), which selects stocks based on variances and correlations, along with other risk factors, rose 6.1% year-to-date while the competing PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which tracks the 100 least volatile stocks on the S&P 500, increased 5.4%. In contrast, the S&P 500 Index only gained 2.5% after experiencing a market correction earlier this year.
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