When the equity market gets rough, many investors instinctively look to low-volatility stocks, funds and/or strategies to protect their portfolios.
It makes sense, but Brian Kraus, product specialist director with the investment consulting group at Hartford Funds, posits that low-volatility products can offer significant long-term growth even if they come with certain challenges.
During a presentation at the Inside ETFs conference in Hollywood, Fla., he laid out the pros and cons of low-volatility ETF investing.
“Regardless of your time horizon, low volatility can play an important role in client portfolios,” he said. “Despite what we all grew up learning about taking excess risk in order to generate returns, and the notion that higher returns come with higher risk, what we know from actual practice and from empirical research is that low-volatility stocks often outperform high-volatility stocks.”
He noted there are two popular ways to implement low-volatility strategies in client portfolios. One is to express a near-term view about the markets and address concerns about downside risk in an effort to help soften the blow when markets go down.
“The second implementation relates to how math works: if I lose 50% of my client’s assets, it’ll take 100% to make that money back,” Kraus said. “So a low-vol strategy might help clients in a strategic way over long periods of time.”
But, he added, expressing a near-term view about markets by investing in a specific factor requires very precise timing capabilities.
“The big challenge with that is it requires accurate timing and that’s tough to do,” Kraus said. “Factors, including low volatility, tend to be mean reverting and move in and out of favor.”
To illustrate that point, he showed a color-coded 10-year chart depicting the returns of various investment factors: size, quality, low vol, momentum and value. The top performers changed annually and the checkerboard appearance of the changing positions of the colors show the up-and-down nature of factor performance. (For the record, low volatility was the second-best performer among the five factors last year with a 2.3% return, and it was tops the prior year at 10.1% and second the year before that at 11.9%.)
“You can see that leadership often changes hands unexpectedly,” Kraus said. “If you’re considering using low-vol investing as a way to express a near-term view, you better be really confident in your view because it could be to the detriment of client portfolios if you get those timing decisions wrong.”