One Way To Implement A Low Volatility Portfolio

Includes: HILO, JNJ, SPLV
by: Roger Nusbaum

This article at Seeking Alpha looked at some data that shows that lower risk stocks when given enough time lead to more reward which is contrary to more risk to get more reward. The specific data may or may not have some sort of bias that skews the conclusion but there is something to this as evidenced by other studies of things like the various buywrite indexes, the putwrite index and the back testing of some of the newer low volatility ETFs that have become popular over the last year or two.

On this site we have referenced John Serrapere's work on what he calls the 75-50 portfolio (he targets 75% of the upside with only 50% of the downside) quite a few times and I believe that someone who saves enough can have a reasonable chance of having enough when they need it by going the low volatility route.

Before getting to the meat of the post, let me say that this is not easy to do mentally. Going low volatility is to accept ahead of time there are going to be a lot of short time periods like quarters and individual years where a low volatility portfolio has no shot of outperforming the broad market. These things should only be expected to win over long periods of time. How difficult is it to remain focused on the long term? In the last two weeks I spoke to one client who was concerned we don't have enough equity exposure and another who was worried we have too much.

For someone who wants low volatility, really can think long term and only wants to spend a little time (not a lot of time and not no time) I think the equity portion of a portfolio could be constructed with two or three low volatility ETFs and two or three individual stocks that would give a good saver a pretty good long term result. Not a market beating result in a given year but a reasonable shot of having enough when they need it while enduring what should turn out to be a smoother ride.

The point with the following names is not to pick the best funds or the best stocks but to explore the concept for the few people with the right temperament.

The PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) has come out of the blocks with $1 billion in AUM and so far has been doing what it is supposed to do. For foreign I would still want a fund that avoids Western Europe and Japan. The EG Shares Low Volatility Emerging Markets Dividend ETF (NYSEARCA:HILO) obviously avoids Europe and Japan and has pretty much done what it is supposed to do since it launched. SPLV shows a 12 month yield of 3.25% and HILO shows an index yield of 6.44%. Where ETFs are concerned you cannot be certain that future dividends will be the same as past dividends. Both SPLV and HILO are in our ownership universe for smaller accounts.

In trying to pick a couple of low volatility stocks to go with the low volatility ETFs consideration needs to be given to the make up of the ETFs. Utilities make up 32% of SPLV and consumer staples is 29%. HILO allocates 29% to telecom stocks. These sectors tend to have high dividend yields which makes them susceptible to rising interest rates. In this context it probably doesn't make sense to pair these two ETFs with some giant regulated utility stock or ma bell because there is no reasonable chance of capturing any sort of zigzag in the portfolio.

There are stocks in the other sectors that have lower volatility and decent/safe yields. From financials I think Chilean and Australian banks can fit the bill, for energy there are plenty of high yielding integrated oil companies from all over the planet to look at, we own Johnson & Johnson (NYSE:JNJ) for clients and hope to be able to hold it forever as an example from healthcare and there are others. The industrial and materials sectors might be difficult for find low beta but there is some yield to be had.

Generically speaking a mix of funds that have little to no financial exposure and a bank stock in a suitably sized position is not an unreasonable blend at the sector level.

This is not buy and forget. Work must still be done on all the holdings. As mentioned a couple of weeks ago the Australian banks face the threat of some sort of housing market problem. This has not necessarily been reflected prices thus far and may never be but the situation must be monitored. Likewise with the ETFs; with that much in just a couple of sectors you need to pay attention there as well. If an announcement was made that next week all regulated utilities were going out of business selling SPLV might be a good idea (I realize the silliness of the example).

Again, for the right temperament and for people willing to put in a little effort this could easily work.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.