In recent years, much has been written about the rising popularity (as measured by fund flows) of low-volatility portfolios with investors. All sorts of explanations have been offered for this phenomenon, almost all of them specious. For example, a popular theory holds that investors are now using low-volatility equity portfolios as ‘bond replacements,’ given anemic yields on traditional fixed-income. More reasonably, another theory simply states that investors are engaging in performance-chasing, as returns on historically less volatile sectors such as utilities and consumer staples have been quite healthy over the last few years. Whatever the explanation for the inflows, one recurring caveat issued by commentators has been that investors in low-volatility funds are trying to have the reward of the stock market without the risks that investing in equities entails as surely at some point volatility would reach even these quiet sectors of the market.
What has been missing from this discussion, however, is whether low-volatility strategies actually have any merit aside from how they might be marketed by fund companies, or how they are perceived by investors. While most people assume that low-volatility applies only to the potential downside of an investment, I believe the real benefit of low-volatility strategies is that the characteristic of low-volatility applies equally to both the ups and downs of an investment. In other words, it is the consistency of returns on low-volatility investments and portfolios that makes them appealing.
To illustrate what I mean by this, let us take a step back and contemplate a real-life scenario from the not-so-distant past.
If I were to present to an investor two prospective investments, – A and B, – that had averaged annualized returns of 18.3% and 16.9%, respectively, over the last 45 years, I would think that, other things being equal, the investor would most likely opt for investment A, given that there seems to be a tendency to project past performance into the future. This simple analysis, unfortunately, ignores the distribution of returns, which matter very much for investors as they 1) most likely will not own the stock for anything like 45 years, and 2) as timing is crucial for any investment, the frequency of consistency of returns matters more than the absolute return on an investment.
As it happens, “investment A” is actually the technology company Intel, and “investment B” is tobacco company Altria. Even though Intel outperformed Altria over the 45-year period by an average of more than 130 basis points annually, the lowest ten-year return for Altria was -1%, while it was -11% for Intel. Conversely, the greatest ten-year return for the two companies was 33% and 54%, respectively. We can see from the distribution of returns that while Intel provided a greater return to investors in aggregate, it seems safe to say that a greater number of investors profited from investing in Altria as there was a much more consistent range of outcomes, almost all of them positive, while Intel’s return pattern was quite the opposite:
One of the main reasons, I believe, that Altria delivered such consistent and steady returns is that the stock avoided bubble-like valuations. Intel, – unfortunately or fortunately, depending on your holding period, – obviously did not, and investors late to the party suffered poor if not negative returns as a result.
This is not just an arbitrary example, nor is it an isolated one. Consumer staple companies like Altria tend to deliver consistent returns not just because their products are needed whatever the state of the economy, but also because they tend to be boring and less prone to over-investment than sectors like technology and even utilities that can be extremely cyclical in nature.
We can see the same phenomenon playing out when we compare the distribution of returns for consumer staples in general, versus both the broad technology sector and the market in general:
Over the last twenty-five-plus years, consumer staples experienced negative five-year returns fewer than ten times, while technology experienced an adverse outcome fifty-eight times, and the broad market fifty-four times. Surprisingly, consumer staples outperformed both the technology sector and the broad market over this time frame, despite having far less volatility. It would be a mistake to assume that staples did well solely because of their ‘defensive’ characteristics; a study of the rolling five-year returns for the three indices reveals that it was the ability of staples to avoid the over-investment of epochs like the tech bubble, – that restraint when stocks move furiously to the upside that I mentioned earlier, – that gave them a real advantage. After all, each boom merely sews the seeds of the next inevitable bust:
So, to come full circle, do low-volatility strategies offer investors a viable option for their portfolio, or is just a market anomaly that somehow defies the law of risk and reward?
First of all, it must be made clear that many popular low-volatility portfolios such as the iShares MSCI Min Vol ETF are completely different from pure-play sector or industry bets such as those I have described above. Investors, as always, should do their homework, and look past the mere name of the fund to understand completely what is owned within it. The low-volatility indices such as those which S&P and MSCI maintain have high turnover, so the composition is always changing. It goes without saying that what has recently been less volatile can certainly become more volatile without much notice. It should serve as a kind of warning that the current composition of the iShares MSCI Min Vol ETF is currently almost one-fifth information technology stocks, a fact which might give prospective investors pause given what I have presented above.
That being said, the evidence seems to suggest that low-volatility investments merit continued consideration by investors. Caveats about their composition aside, low-volatility strategies have been shown to generate both higher and more consistent returns in both the large cap space (as measured by the S&P 500), and in the small cap space (as measured by the S&P 600). The strategy has shown promise even in areas like emerging markets. The obvious questions are whether the popularity of low-volatility strategies will dull their effectiveness, or if valuations in the underlying investments have been stretched too far. Time will tell, but my own opinion is that human nature, more than any other factor, is what truly drives markets to extremes, and because low-volatility investments seem to be better insulated against these extremes than many other strategies, they should continue to do reasonably well.
Additional graphics:
S&P 500 vs S&P 500 Low Vol Total Return:
S&P 500 vs S&P 500 Low Vol Distribution of Returns:
S&P 600 vs S&P 600 Low Vol Total Return:
S&P 600 vs S&P 600 Low Vol Distribution of Returns:
Both the author and clients of Fortune Financial hold positions in Altria and Intel.
Disclosure: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
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