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Parsing Low Vol And Low Beta

May 29, 2012
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Think low volatility and low beta are the same? Think again.

Russell offers two ETFs that track modified versions of the Russell 1000, one with a low-beta strategy (NYSEArca: LBTA), one with a low-volatility strategy (NYSEArca: LVOL).

Over a three-month time horizon, each of these funds delivered sufficiently divergent returns to make me want to understand what the difference means to investors.

Here’s what I found:

Over the three-month time horizon starting Feb. 17, nearly 5 percentage points of returns separated LBTA and LVOL, with LBTA eking out actual gains. As the graph below shows, LBTA finished in the black, gaining a little over 1 percent, while LVOL fell about 3 percent.

VOL vs LBTA Price Performance

A 5-percentage point difference over three months is nothing to scoff at, so it would be best to stop using “low-beta” and “low-volatility” synonymously and find out what separates these two factor-based approaches to investing.

The answer is that beta is a relative measure and volatility is an absolute measure. Let me explain.

Beta measures how much the price of an asset moves relative to the movement of the market. Volatility, on the other hand, is an absolute measure of price fluctuations in the asset and pays no regard to movements in the broader market.

We generally expect the two measures to yield similar values because most assets exhibit some significant level of correlation with measures of the “broader market.”

As an investor, if I were looking at a low-volatility portfolio I would expect to find assets that also have low betas. Conversely, inside a low-beta portfolio, I would expect to find assets that also exhibit low volatility.

As it turns out, not only is neither assumption theoretically sound, but empirical evidence also suggests the contrary.

 

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