Low volatility ETFs: do they stack up?

Oct 12th, 2013 | By | Category: ETF and Index News

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By David Stevenson –

Apologies for sounding like a broken record, but I want to return yet again to the hoary old subject of smart beta and the voguish hunt for minimal volatility.

Low volatility ETFs: do they stack up?

Low volatility ETFs: do they stack up?

Lyxor‘s recent cross-listing of the Lyxor UCITS ETF MSCI World Risk Weighted (WDRL) on the London Stock Exchange (the fund was initially listed on the NYSE Euronext last year) has prompted me to try and find out whether the first wave of low volatility ETFs (I include minimum volatility and minimum variance ETFs in this grouping) has actually delivered on their promise.

Just in case you haven’t been reading any ETF Strategy articles (shame on you), you may be aware that we are mid way through a terrible outbreak of a virulent virus called “smartbeta-itis”. This odd-sounding disease (nasty rashes, followed by speaking in strange tongues) crops up when ETF enthusiasts are left speechless after a particularly nasty verbal mauling by active fund managers.

The argument goes something like this:

Active Fund Management fan: “You can’t possibly want to buy into that index in a simple passive way? I mean do you really want to put 56% of your money into XYZ large US technology leviathan. I mean all those growth stocks are junk and you’d just be repeating that Cisco disaster from the last decade. At least our fund managers can manage the risk of investing by avoiding those true junk stocks that are overvalued by the market.”

Passive Fund management enthusiast (furrowing brow and sipping a skinny Cafe Latte): “Hah hah, none of that matters over the long term anyway as the market eventually works out its own value and frankly second-guessing whether something is “worth” the price is a mug’s game. It all averages out over the long term!”

Active Fund Management Fan: “Yeah but most investors don’t have that long to wait! They’d be dead by then. If investors only have a 5 to 10-year time frame at most, then they don’t want to get stuck with those junk stocks in your index-tracking fund! Managing that risk by our active fund managers more than makes up for our extra 127 basis points in charge.”

Passive Fund management enthusiast: “Good point – let me go away and torture the data.”

Smart beta is of course the answer to these broad attacks from the active fund management brigade and the risk argument – using quant screens, investors can essentially end up with whatever tilt their heart desires, all nicely wrapped up within a lower cost ETF.

The good news is that a defensive, smart beta strategy of focusing on stocks with less volatility seems to be winning a large audience. So, as the competition hots up between ETF providers, including the likes of iShares, SSgA SPDR, Ossiam, PowerShares and VelocityShares, one is inevitably forced to ask the big $64 million question – has low or minimum volatility as a smart beta strategy actually delivered on the goods so far?

Now at this point in the debate, one has to strike an important note of caution, which is that low volatility ETFs haven’t been around for terribly long which means that any conclusions need to be taken with a pinch of salt. However, a glance at the returns of a selection of well-known low volatility ETFs over the past 12 months reveals a number of interesting, though interim, conclusions, of which the major one is that very few have either delivered superior returns or delivered superior risk-adjusted returns as measured by the Sharpe ratio.

The good news, though, is that nearly all have delivered lower volatility, which I suspect exactly what was intended. But I can’t help but think that many investors and their advisers might feel a little under-whelmed. Whilst these funds may have done what they said they would do (i.e. deliver exposure with lower volatility), investors truly do want to have their cake and eat it!

Lurking in the background is a deeper question which actually gets back to the core of my earlier debate. Investors really do want to control risk but they also actually like some positive, pro-active biases built into their fund stock selection. Avoiding certain types of stocks tends to push some of the more basic smart beta indices into other equally dangerous concentrations (such as an overabundance of consumer staples or utilities stocks, for example).

Cue the MSCI World Risk Weighted Index and its accompanying Lyxor ETF. On paper, this is very similar to all the other index trackers that use volatility as a key measure but scratch beneath the surface and you discover that actually it also benefits from a much more extensive form of diversification, with the top 10 stocks in the index all weighted between 0.22% and 0.26% of the index.

To understand this point, look at the top five holdings in the benchmark MSCI World Index, which are Apple (at 1.6%), Exxon (1.38%), Microsoft (0.94%), Johnson & Johnson (0.85%) and GE (0.85%). In the risk-weighted version of the index those top holdings are McDonalds (0.25%), Pepisico (0.24%), Southern Co (0.24%), Johnson & Johnson (0.24%) and CLP holdings (0.24%).

What seems to be at work here is the weaving together of three important strands: (i) Risk management based on volatility as a measure, (ii) Risk management by more extensive diversification i.e more, smaller holdings, and (iii) Returns management by increasing exposure to small caps.

Or, as MSCI itself puts it, “the index employs a simple yet effective method to overweight low risk and smaller market cap stocks while maintaining broad market exposure”. MSCI in its own research paper on the index goes on to explain this strategy in a little more detail: it reckons benefits from the index should include a reduction of portfolio risk by about 10% over the long-term, with less drawdown than the broad market, and higher risk-adjusted returns.

The important point here is that this is a less concentrated, more diverse low volatility index with many more smaller names inside it. In effect it’s a mutant pairing of what a low volatility index might look like if it ran into a maximum diversification index and then included a modified equal weight tilt for good measure! The rather strange resulting creature (and accompanying ETF) is echoed by research from the academic index specialists at EDHEC-Risk Institute who’ve also looked at which smart beta strategies work. Their main insight is that controlling risk is not just about minimising the most volatile stocks but also building a portfolio with as much diversification as possible!

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