Academic research and investors have found that equities exhibiting low volatility have outperformed over the long-haul by diminishing drawdowns during sell-offs while still allowing investors to participate in any upside potential. The same low-volatility effect can also be applied to fixed-income exchange traded fund investments to improve long-term returns too.
“The low volatility effect in equities has been well documented in academia for decades,” S&P Dow Jones Indices’ Hong Xie, director of global research and design, and Aye M. Soe, senior director of global research and design, said in a note. “Our research shows that low risk investing can be applied to fixed income as well.”
Many have studied the effects of low-volatility factor on equity performance. For instance, more recently, Blitz and Vliet (2007) constructed decile portfolios based on the rankings of stocks by their three-year realized volatility, revealing that the volatility of the top decile portfolio, which contains the low risk stocks, was about two-thirds of the market volatility, whereas the volatility of the bottom decile portfolio had a standard deviation that was almost twice that of the market. The researchers basically found that the top performers consisted of low-volatile stocks that exhibited low volatility and the bottom performers showed swings twice as severe as the broader market.
Given the beneficial qualities of a low-volatility focus on the equity side, some are beginning to consider the low-vol factor for inclusion in fixed-income portfolios. For instance, Carvalho, Dugnolle, Lu, and Moulin (2014) looked to the low volatility factor across major developed fixed income markets and discovered lower risk bonds generated positive alpha, irrespective of the currency or market segment that they considered.
Given this backdrop, IndexIQ recently rolled out the IQ S&P High Yield Low Volatility Bond ETF (NYSEArca: HYLV) to help investors gain a smoother ride in a traditionally riskier segment of the debt market.
The high yield low volatility bond ETF tries to reflect the performance of the S&P U.S. High Yield Low Volatility Corporate Bond Index, which is comprised of U.S. dollar-denominated high-yield corporate bonds that have been selected using a rules-based methodology that identifies securities expected to have a lower volatility relative to the broader high-yield market.
Specifically, each bond is ranked according to its marginal contribution to risk, or MCR, a measurement of the amount of risk a security contributes to a portfolio of securities. The measure is calculated using a bond’s duration and the difference between the bond’s spread and a weighted average spread of the bonds in the broader index universe. Those with a higher MCR will add more credit risk than debt with a lower MCR. The underlying index will only select the 50% of bonds measured to have the least credit risk based on their MCR.
In looking at back tested data with a base date of January 31, 2000, the underlying index generated improved risk-adjusted returns.
“The index demonstrates trend behavior similar to the benchmark S&P U.S. High Yield Corporate Bond Index, yet with less volatility,” Xie and Soe said in a note. “Cumulatively, the annualized return of the S&P U.S. High Yield Low Volatility Corporate Bond Index (at 7.12%) was 7 bps lower than that of the broader universe, but the ratio of return to volatility improved by 0.19 to 1.01 due to reduced volatility.”
By screening for the low-volatility factor in high-yield corporate debt, the low-vol focus has achieved its goal with reduced return volatility, improved performance in down markets than in up markets and diminished drawdown in stressed markets.
Potential investors, though, should keep in mind that the more conservative investment strategy will underperform the broader speculative-grade debt market during periods of strong bull rallies. Additionally, the defensive low-vol play also exhibited lower yields to achieve its risk reduction, compared to the broad-based high yield market.