Do Low Volatility ETFs Equal Higher Returns?

There are several risks on the horizon for global stock markets capable of elevating levels of market volatility. Could a strategic beta ETF be the answer to investors' prayers?

Dimitar Boyadzhiev 6 November, 2015 | 9:00AM
Facebook Twitter LinkedIn

As the market events of the past summer reminded us, volatility is a fact of investing life. However, for many investors it can be a rather unnerving experience; and it is one that has become more frequent. Data shows that the number of trading days in which popular indices, such as FTSE 100 and S&P 500, have moved over 2% either up or down, has more than tripled over the past three decades. This is perhaps unsurprising, given the financial market rollercoaster we have experienced since 2008.

Looking ahead, there are several risks on the horizon for global stock markets capable of elevating levels of market volatility. Of these, China’s failure to manage its slowdown is the one playing strongly in investors’ minds, as it has the potential to reverberate worldwide.

Low Volatility as a Strategy

Against this backdrop, a growing number of investors have been turning to low volatility strategies in a bid to set their equity portfolios on a smoother path and reduce overall risk. The basic idea of low volatility – also known as minimum variance – strategies is that of selecting and weighting constituents on the basis of historical volatility. This is a simple, but seductive story. Academic studies show that low volatility strategies have delivered a consistent 20-40% reduction in volatility relative to the broad market; depending on geography and period.

Putting the Strategy in an ETF Wrapper

Capturing these well-researched equity strategies in a rules-based benchmark form has become increasingly easy over the past years. ETF providers, always with a keen eye on innovation, have launched a raft of products tracking these indices, thus allowing investors low-cost access to this strategy.  Making part of what we at Morningstar define as “strategic beta” and some providers call “smart beta”, the market of low volatility ETFs in Europe has grown to €4 billion and stands only second to dividend-enhanced ETFs in terms of AUM and product proliferation. The most popular low volatility themed ETFs, in terms of AUM, are offered by iShares and Ossiam.

The underlying indices select components on the basis of historical volatility versus the broader market, as measured by a standard market cap benchmark; i.e. the parent index, as well as their correlation relative to other constituents. To limit unintended country or sector concentration risk, the indices may apply additional constraints. For example, MSCI does not let the country and sector weights of its minimum volatility strategy deviate more than 2.5% and 5%, respectively, from the parent index. The end result is a benchmark that, while respecting key characteristics of its market cap parent, has a less volatile returns profile.

Can A Defensive Strategy Outperform?

By definition, low volatility strategies are defensive in nature.  This brings up an important question; does this limit returns over the long term? After all, when putting money aside for the long term, investors place more emphasis on maximising return potential; and so one may assume that a low volatility – and thus defensive  - equity strategy  may not be the best option.

The data tells us otherwise, however.  In the past 10- and 15-year periods out to the end of September 2015, the MSCI World Minimum Volatility Index has outperformed its parent – MSCI World Index – by 1.3% and 2.6% in annualized terms. This is attributed to the low volatility strategy’s ability to cushion the impact of falling markets, which effectively reduces the upside needed to recoup losses when markets turn bullish. Or put it differently, compared to a standard market cap, a low volatility index should have less catching up to do.   

Closer to home, the MSCI Europe Minimum Volatility Index has outperformed its parent – MSCI Europe Index – by over 20% on a cumulative basis.  Partly explaining this outperformance is the index’s positive bias towards UK, Swiss and Nordic companies, and its underweighting of Eurozone stocks. The high volatility and consistent sell-off of Eurozone equities during the region’s debt crisis meant that their allocation in the benchmark was significantly reduced. This effectively shielded it against steep losses.

A Word of Caution

Low volatility ETFs can be a good choice for investors wanting to smooth out volatility without necessarily having to give up returns over the long-term. However, as with all strategic beta funds, a word of caution is warranted. The past decade has seen financial markets hit by a number of systemic risks, which have played in favour of a low volatility strategy. But investors should be aware, the sector and country bets that low-volatility indices take by deviating from to the broad market will not always pay off. 

TAGS

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Dimitar Boyadzhiev  is a Passive Strategies Research Analyst for Morningstar