Low Volatility ETF Debate Rages On

It seems the debate around low volatility and minimum variance exchange traded funds is far from over.

At this week’s ETF.com conference in the US, industry experts have been debating what the terms actually mean and how they can potentially mislead investors, particularly in the retail sphere.

For example, did you know that a low volatility portfolio is not the same as a portfolio of low volatility stocks?

Earlier this year we had several industry experts point out the danger of retail investors flocking to these strategies, due to high concentrations in certain sectors like utilities.

But does a low vol ETF actually reduce risk in your portfolio? Not according to Nick Cherney, chief investment officer and co-founder of US index company VelocityShares.

“I’m not aware of any academic research piece that says that low vol stocks are a way to get lower risk portfolios, as you’re focusing on other factors like sector weightings,” he said.

The low vol strategy outperformed in 2008, but what if we find ourselves in the midst of another crisis brought on by raising interest rates? Low vol ETFs will get crushed, says Cherny.

“At the end of the day what are you trying to achieve with a tilt to low vol stocks? It’s a tilt to positive alpha. It’s very misleading to say that a tilt to lower volatility stocks leads to lower risk portfolios,” he said.

So you need to compare strategies. Look at the index construction – whether it ranks stocks by volatility, for example – as well as weightings to certain sectors and how often the index rebalances.

“Very different construction processes can lead to differences in exposure and performance over time,” said David Koenig, investment strategist, indexes, at Russell Investments.

There have been concerns that low vol strategies have become a crowded market after a good run in performance over the past two years.

Vitali Kalesnik, senior vice president, head of equity research at Research Affiliates LLC, said that if low vol stocks become popular in the market place and people struggle with trading, you will see this reflected in declining value metrics and forward-looking metrics.

“Make sure you know how much you’re paying per unit of economic value, per unit of future returns,” he said.

It’s a good idea to take a close look at fees and any other factors that feed into future earnings, enabling you to compare products.

Low vol solutions also tend to run a pretty high tracking error versus the benchmark. And if the market rises for a prolonged period, you’re likely to be left behind with a normally significant overweight in defensive stocks.

Market cap and smart beta strategies are not mutually exclusive, as they outperform in different conditions. Last year the Russell 3000 Index returned 38 percent. Not bad for plain old market cap.

Therefore, don’t be too quick to discount the traditional market capitalisation weighted benchmarks unless you can be confident you have found a good alternative.