The recent volatility in the stock market has many investors trying to figure out how to maintain some exposure to equities, while limiting their exposure to the big ups and downs of the major equity indexes.
One alternative is to manage a portfolio’s beta, a measure of how a portfolio tends to respond to movements in a broad index (most commonly the S&P 500 Index). Stocks with values of beta less than 100% (1.0) tend to react less to changes in the broader market. (For example, utility stocks typically have betas less than 1.0, because their earnings are largely independent of broader market volatility.) Low beta stocks tend to have lower volatility than the market as a whole; however, the terms “low-beta” and “low-volatility” are not entirely synonymous.
In recent months, we have seen the launch of new ETFs that invest in low-beta/low volatility stocks. I am intrigued by these new funds because there is high-profile research dating back to 2003 that discusses how low-beta investing can deliver attractive returns. So it’s surprising to me that there have not been more funds focusing on a low-beta strategy.
Three brand new funds that target low beta (and low volatility) are:
PowerShares S&P 500 Low Volatility Fund (NYSEARCA:SPLV): Invests in the 100 stocks from the S&P 500 Index with the lowest beta performance (as determined by the underlying index which is maintained by Standard and Poor’s). The ETFs has an expense ratio of 0.25%. (Source: PowerShares S&P 500 Low Volatility Fund prospectus, available at http://www.invescopowershares.com/).
Russell 1000 Low Volatility ETF (NYSEARCA:LVOL): Invests at least 80% of total assets in comprising the Russell-Axioma U.S. Large Cap Low Volatility Index. The ETF has an expense ratio of 0.49% (Source: Russell 1000 Low Volatility ETF prospectus, available at available at http://www.invescopowershares.com/).
Russell 1000 Low Beta ETF (NYSEARCA:LBTA): Invests at least 80% of total assets in common stocks that comprise the Russell-Axioma U.S. Large Cap Low Beta Index. The ETF has an expense ratio of 0.49% (Source: Russell 1000 Low Beta ETF (LBTA) prospectus, available at available at http://www.invescopowershares.com/).
Are ETFs just a conservative play for the risk-averse investor? Or is there another reason that low beta stocks might make sense?The Case for Low Beta Investing
Why would investors be interested in investing specifically in low volatility/low beta stocks?
If we believe that markets are efficient, and that the return from a stock portfolio is determined by the amount of risk (or volatility) in the portfolio, then it would not make a sense for investors to invest in a portfolio of low volatility/low beta stocks. However, there is considerable evidence that low beta stocks tend to outperform.
In an article published in 2010, I explored a range of research into the risk-return relationship that suggested the traditional views of how returns are related to various sources of risk, are not correct. Research performed by professors at Princeton, Yale, the University of Chicago and Dartmouth suggest that portfolios selected on the basis of low beta will not only be less sensitive to market swings, but have historically delivered higher returns than what traditional financial theory predicts.
Research by Eugene Fama (Chicago) and Ken French (Dartmouth) popularized the idea that value stocks and small cap stocks generate out-sized returns (the so-called size and value factors). What is less well-known is that their research also found that stocks with low beta tend to out-perform :
“…funds that concentrate on low beta stocks, small stocks, or value stocks will tend to produce positive abnormal returns …even when the fund managers have no special talent for picking winners.“
A more recent academic study written in late 2010, also finds that … low beta stocks tend to outperform. This study examines a wide range of non-U.S. equity markets, corporate bonds, and futures.Folio Investing’s Low Beta Strategy
ETFs that target low beta stocks as the core of their portfolio strategy are very new. In fact, the three funds that I discussed above are less than three months old.
However, back in February 2008, Folio Investing started tracking a low beta strategy that I designed. The research that motivated this portfolio suggested that a low beta approach would not only help protect portfolios against market downturns, but could also potentially outperform the broader market.
In fact, Folio Investing’s low beta strategy outperformed the S&P 500 Index over the past three years. Here are the latest performance figures:
|Year to Date||11.18%||7.43%|
|Three year (Annualized)||8.33%||4.25%|
|Five Year (Annualized)||N/A||3.20%|
|Volatility (One Year)||11.55%||14.16%|
Source: Folio Investing (Data available through July 5, 2011).
It’s not surprising that a low beta portfolio outperformed the broader index over the past three years. Due to market volatility, investors moved from riskier assets to more conservative ones. What is surprising is that Folio Investing’s low-beta approach returned almost as much as the S&P 500 Index over the last year—when the market rallied.Final Thoughts on Low Beta
Low beta strategies can provide risk-averse investors with a way to maintain some of the upside potential from equities, while managing overall portfolio risk. Today, there is a growing body of research that suggests that low-beta stocks may provide higher risk-adjusted returns in the same way that portfolios with a value or small-cap tilt may provide higher risk-adjusted returns.
For investors, there are a variety of ways of building a low-beta portfolio. The three ETFs and the Folio I included here use quite different approaches. Therefore, you should perform your own due diligence to determine the investment that is suitable for your needs.
As the track records of low-beta strategies grow and the body of research grows, I expect that the interest in building low beta portfolios will also continue to grow.
Disclosure: Investments in ETFs and Folios are subject to investment risk including the loss of the principal amount invested. Investors should consider the investment objectives and risks of ETFs and Folios, as well as the fees and charges associated with them before investing. The prospectus of an ETF contains this and other information about the ETF. For more information regarding the Folio referenced in this article, please visit our website. Past performance does not guarantee future results.
Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.