Preparing For The DOL Fiduciary Rule: The Role Of Low-Volatility ETFs

Summary

• The DOL new rule will push down advisors' fees and create homogenization, among other things.
• I recommend worried advisors to consider low-volatility ETFs as they prepare for the full implementation of the DOL rule.
• Rolling diversification plus gains statistically equivalent to the general market are two key advertising points that put you ahead of buy-and-hold ETF advisors in clients' eyes.

The DOL rule has led to its first case: A suit against Scottstrade for holding sales contests that can be considered as not having their clients’ best interests in mind. In my line of work, I encounter many financial advisors, and nearly all of them are worried about how the DOL will affect their work and livelihood. While the rule will not go into full effect until July 2019, we all saw suits coming, even with the partial implementation we have now.

The strangest part of this rule is that it brings little new to the table, merely placing physical red tape over abstract lines that have been long recognized and accepted. Financial advisors, by the nature of their careers, are already held to fiduciary standards - the new rule simply gives ammo to clients who feel wronged for whatever reason. I think of the rule as the “Warning! Hot!” text that is now printed on McDonalds’s coffee cups: The coffee was always hot, but now I don’t have to blame myself when I’m burned as I juggle two cups of joes while skateboarding.

Both advisors and clients lose freedom. Clients have fewer options, as certain types of transaction-based accounts will be eliminated. Advisors suddenly find themselves walking on thin ice and being pushed to make “safe” decisions, such as merely shoving everything into ETFs because to do otherwise could be seen as exploiting clients (after all, if the literature states that advisors cannot outperform an ETF, to make multiple stock transactions in place of the client is clearly not in the client’s best interests).

The best advisors are going to slog through this. At the request of my financial advisor clients and readers, here's my advice to them. But let me start with a bit of optimism: By ensuring their investment practices are objectively superior to shoving cash into an ETF, financial advisors will actually gain clients, as their competitors lose their competitive advantages under the DOL rule.

Prove Your Alpha

The new rule will push down fees, as only charging clients the lowest possible fees will be seen as aligned with their best interests. This leads to an environment in which popularity equates to profitability. As an increasing number of advisors say “screw it,” and toss their hats into the ETF ring, investors will increasingly view advisors an homogeneous – except for those advisors who offer unique, proved methods of obtaining excess returns.

The overarching goal for everyone is to increase your investors’ return. And while you might already know from your experience the methods to do so, you cannot ethically recommend your method over ETF investing without hard evidence. Suddenly, statistics and back-testing become much more important in this field.

I’ve back-tested both my advisor clients’ strategies and my own. I can tell you that strategies beating the market are not so rare. Under the DOL rule, having an innate, intuition-based alpha, such as that built into Warren Buffett’s mind, is more a curse than a blessing. But experimentation leads to strategies with alpha and the statistical backing that allow for their ethical recommendation.

Reduce Variance

A strategy with a large variance (or standard deviation) is seen as high-risk and can therefore be justified by your enemies as not in the best interests of your clients, given particular risk tolerance levels. Whether you are developing a new strategy or honing a current one, the easiest DOL-friendly change you can make is to reduce its variance. While many simply add diversification to attain this end, diversification is not the optimal way – and it is also not a guaranteed method of reduced variance.

Still, an easy way to reduce variance is to dilute your strategy with a lower volatility strategy. For example, divide your strategy’s allocation in half, dedicating the new half to a low volatility ETF. This will not only reduce your clients’ fees but will allow you to increase the volatility in the stock half of the portfolio, an important technique due to excess returns being more likely with higher volatility holdings.

As for low-volatility ETFs, I can give some recommendations. A particular client of mine works deeply with these ETFs, restructuring them by pruning and adding, as justified by backtests over multiple decades. That’s more for the advanced class. Here, I just want to give you the results of my backtests and analyses of individual low volatility ETFs run as seasonal strategies.

As the volatility regime changes every few years, it is best to run your data over the current regime. The seasonal strategy I’ve applied recognizes that some low-volatility ETFs see their volatilities spike during certain seasons. We aim to shave off extra volatility by avoiding certain months.

The ETFs

The ETFs used in this strategy follow.

iShares Edge MSCI Min Vol Global ETF (ACWV)

A highly cost-effective ETF for the diversity it offers, ACWV gives exposure to practically the whole market while protecting investors from intense volatility spikes. While it is used for buy-and-hold investing, my backtests show a clear historical seasonality that makes it more suitable for a strategy such as the one I’m about to offer. Going over its 408 holdings to discover the root of that seasonality would be a highly time-consuming process, but for the sake of convenience here are the top handful of ACWV’s holdings:

SPDR SSGA US Large Cap Low Volatility Index ETF (LGLV)

In contrast to ACWV, LGLV focuses on only US large-cap stocks. After the first quarter of the year, US large-cap growth tends to exceed global growth (in these low volatility choosings), making LGLV the preferred choice. The seasonal chart can prove informative:

VictoryShares International Volatility Weighted ETF (CIL)

It might seem odd to use two separate international, low-volatility ETFs for this strategy, but CIL has a different seasonality from ACWV. A quick look at ACWV’s holdings vs. the national exposure of CIL clarifies the reason for the difference - CIL is much more “non-US” than is ACWV:

PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV)

You can further assess volatility spikes by avoiding rate-sensitive stocks. This is especially relevant now, with changing rates, and should be further emphasized later in the year, when funds create selloffs in the large caps as a part of their rebalancing efforts and attempts to reduce risk. I find it hard to spontaneously think of rate-protected stocks, so here’s a quick look at CIL’s holdings:

The Strategy

The low-volatility portfolio follows.

Hold ACWV from January to May.

Hold LGLV from May to August.

Hold CIL from August to October.

Hold XRLV from October to December.

The strategy over the past three years and its statistics follow.

The gains here are the same as the general market (as measured by SPY) over the past three years. The advantage of this strategy is lower volatility (75% lower), higher Sharpe (9%), and equal CAGR - all without having to sacrifice market gains. Rolling diversification plus gains statistically equivalent to the general market are two key advertising points that put you ahead of buy-and-hold ETF advisors without putting yourself at risk of overstepping the DOL rule.

Presented well and tied to your unique investment pattern, such a portfolio is an easy way to differentiate yourself from your competitors who are likely struggling to adapt their businesses for July 2019.

Notes:

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Note on sources: All unlabeled figures are created by me. I use R to pull data directly from Quandl to perform analyses and create charts. Charts with blue backgrounds are from Etrade Pro. Fundamental graphics are from a paid subscription at simplywall.st.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.