Low Volatility ETFs: The Best Investment You've Never Heard Of

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Includes: EFAV, IVV, SPHB, USMV, VYM, VYMI
by: Logan Kane
Summary

In their struggle to hit unrealistic return targets, investors consistently over-invest in high volatility assets, leaving low volatility assets undervalued.

Low volatility assets within asset classes show much stronger risk-adjusted performance than high beta assets.

You can use this anomaly to make a higher return in your portfolio by allocating more money to underpriced assets.

Seeking Alpha contributor Ploutos recently wrote an excellent article about how using low volatility ETFs allows you to allocate more of your portfolio to equities for the same level of risk. His research showed that a portfolio of 80 percent low volatility stocks and 20 percent bonds beat a portfolio of 60 percent S&P 500 and 40 percent bonds by around 1.3 percent per year with about 0.25 percent per year less risk.

I did some research of my own and found a couple of interesting trades out of this anomaly that can appeal to investors with various tolerances for risk. You should care about the low volatility effect because applying it is likely to allow you to make a higher return on your investments.

I'm going to assume in this article that you've been exposed to the concept of beta and the capital asset pricing model. If you'd like, you can get a quick refresher here!

Why does low volatility investing work?

In a nutshell, low volatility investing seems to work because market participants collectively bid up the prices of risky assets in order to hit unrealistic return targets, leaving high beta assets overpriced and low beta assets underpriced. Additionally, volatility may be a quality signal for stocks, with low-quality/less profitable companies experiencing more volatility than high-quality companies with stable cash flow and earnings growth.

This effect is referred to as the "low volatility anomaly." Academic research shows that retail investors tend to invest in what they're familiar with. This typically means investing the stocks of large, popular, familiar companies. This causes valuations to rise for these kinds of companies compared to what they otherwise would be and causes volatility in those shares to increase.

While it's less famous than the value effect, research has shown that the volatility anomaly exists in every observable market in the world.

The fundamental theory that they teach you in freshman level finance classes in college is that more risk = more return. But what if your college professors were all wrong? When you dig deeper into the catacombs of portfolio theory, you find this that it just isn't true that higher risk equals higher return. It's quite contradictory.

In business and in their personal relationships, people typically understand to avoid risk and seek reward.

However, once you give them casino chips or an online brokerage account, people forget everything they've learned from real life and aggressively pursue risk at the expense of returns.

Some high beta stocks have done very well (like Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL)), but in the aggregate, low volatility stocks get significantly higher risk-adjusted returns than high volatility stocks. Why is this? There are a few theories. One is mutual fund managers pile into high beta stocks in an attempt to beat their benchmarks. And why wouldn't they? A lot of times, fund managers' bonus compensation is tied to outperforming their benchmark, regardless of exactly how they do it. If you need to catch up with the index, you'll have an incentive to pile on the risk to get that performance bonus, even if it's not necessarily the best thing for your investors. Because of these misaligned incentives, sophisticated traders have an easy way to profit from the clumsiness of the multi-trillion-dollar mutual fund industry.

You see this low volatility effect in play both within asset classes and between them. For example, high volatility stocks tend to have poorer risk-adjusted returns than low volatility stocks. In fixed income, shorter duration bonds tend to have better risk-adjusted returns than long-term bonds. And finally, equities, in general, tend to have somewhat lower Sharpe ratios than bonds.

Just because an anomaly exists doesn't mean that it's easy to exploit or that it will go away. This is part of why the low volatility anomaly has been allowed to persist. To enjoy the fruits of the low volatility anomaly, you likely will need to accept one of two risks, leverage or concentration. Both are fine but which is better for you depends on your individual preferences. Both approaches have been shown by the research as risks that are likely to be rewarded.

Using Equity Concentration to Exploit the Low Volatility Anomaly

This is the way that the majority of investors are going to be the most comfortable with.

Ploutos recommended applying some equity concentration to a traditional 60/40 portfolio to get a higher return for a little less risk. This makes sense. Assuming bonds return about 4 percent and equities return a little under 10, taking 20 percent of the portfolio that would be in bonds and putting it in the higher returning asset yields about 1.2 percent per year in additional return. Lo and behold, the portfolio returned 1.3 percent more per year.

This is a simple, effective, and actionable plan. If you're a retiree with a $2,000,000 portfolio, I'd estimate that this low volatility method will give you a roughly $25,000 per year boost in expected value/income, plus an above average dividend yield.

As you can see, going from 60 stocks/40 bonds to 80 low vol stocks/20 bonds doesn't add any risk to the portfolio and is backed by decades of research to get you higher returns. Of course, the model was fairly simple for illustration purposes, but it's worth thinking about. If it were up to me, I'd combine low volatility stocks with value stocks, where my favorite proxy is the Vanguard High Dividend Yield ETF (VYM), putting some cash to work in each strategy. It depends on your allocation, but for US stocks, I'd recommend the iShares Edge MSCI Minimum Volatility USA ETF (USMV) for the low volatility tilt, and for international stocks, I'd recommend buying the iShares Edge MSCI Min. Vol. EAFE ETF (EFAV).

Also on the topic of international stocks, if you think the problem of US investors concentrating risk in high beta assets is bad, I'd like to introduce you to Europe. Quantitative easing has driven 10-year bond yields in Germany to zero. France clocks in around 0.5 percent per year on their 10-year yield. In the United Kingdom, yields are around 1 percent for the same 10-year bonds. At the same time, most international equity markets are implying roughly 10-11 percent returns. So what do investors do over there? They plow money into high volatility assets to hit their return targets while still allocating money to their overpriced and central bank manipulated bonds!

Look here at the low volatility anomaly in the US and abroad. The iShares Core S&P 500 ETF (NYSEARCA:IVV) corresponds to the S&P 500, USMV is US low volatility stocks, EFAV is international low volatility stocks, and the iShares MSCI EAFE ETF (NYSEARCA:EFA) is international stocks.

Source: Portfolio Visualizer

This sample occurred during a period that is likely to be favorable towards high volatility assets, which tend to perform best in uptrending markets and worst in bear markets. In truth, high volatility assets are even poorer generators of wealth than they appear from the chart.

Maybe they shouldn't be plowing money into high volatility assets after all. You could argue that for the US, the relationship between low volatility stocks and the S&P is efficient because you'd have to apply a little leverage to translate the higher risk-adjusted returns of low volatility stocks into higher returns than the S&P.

But in Western Europe? Investors over there are clearly over-allocating to high volatility assets in a desperate attempt to hit the return targets they need to have enough money to pay their future liabilities (like their burgeoning pension systems). Not only have low volatility stocks win on a risk-adjusted basis, but they've also won on an absolute basis. Investing in stocks with weak fundamentals quickly bites you, however, as the returns of high volatility stocks have shown.

It turns out that applying a low volatility filter has been just about the only way to squeeze respectable risk-adjusted returns out of falling equity valuations abroad; the other being allocating to international dividend/value funds like the Vanguard International High Dividend Yield ETF (VYMI).

Upping equity allocations but to lower volatility stocks is a solid way to get better returns for less risk. However, the most effective way to exploit the low volatility anomaly is to use leverage.

Using Leverage to Exploit the Low Volatility Anomaly

It might seem a little weird to get excited about a product like USMV, which hasn't even outperformed the S&P 500 since its inception. However, this is a blessing in disguise as it keeps investors from piling in and taking away the benefits by bidding up the underlying stocks. I already showed you how upping your equity allocation from 60 percent to 80 percent but in low volatility stocks allows you to exploit this, but the most elegant way is to use leverage.

95 percent of investors aren't going to touch this product because they don't understand it. However, if you're willing to use a little leverage, you can do something that finance people call "betting against beta" to juice your returns.

Here's how it works.

The return of the S&P 500 over this time was 14.39 percent and the standard deviation was 10.93 percent.

The return of USMV was 13.54 percent and the standard deviation was 8.74 percent.

Judging by the data, we can safely assume that the S&P is about 25 percent more volatile than USMV. So, to even things up, we apply 1.25x leverage to USMV.

Now, our return (assuming a 1.5 percent financing cost from 2012 to current at Interactive Brokers) is 16.62 percent, with roughly the same risk as the S&P 500.

This is a pretty easy and low-risk way to beat the market. Sure, there's no 100 percent chance that this will hold in the future, but combining the low volatility anomaly with all of the other pricing anomalies I've studied in a diversified portfolio yields a risk profile that I'm quite comfortable with. Of course, this example is oversimplified and I'm not recommending someone go out and put all their money in USMV like this, but the principle of using leverage on a portfolio diversified across asset classes does hold up with USMV as a piece of the puzzle.

To this point, here you can see the risk and return for the S&P 500 (IVV), low volatility stocks, and high volatility stocks Invesco S&P 500 High Beta Portfolio ETF (SPHB). It's clear from the data that low volatility is preferable, and that there is little to no correlation between volatility and returns in US stocks over this period (note that the X-axis is very stretched here compared to the Y-axis).

Source: Portfolio Visualizer

Once again, applying a little leverage to safer assets beats concentrating risk in high beta assets like SPHB, or even assets like the S&P which are indifferent to risk.

Where things get really interesting is when you combine domestic and international minimum volatility ETFs with my existing quantitative models that I've developed for ETFs and futures. Applying leverage to a truly diversified portfolio of different asset classes with good risk management seems to be a much better bet than picking stocks, and requires less luck.

One risk I will note is that academic research does show that when interest rates are higher, this strategy is less effective, but still works reasonably well. Other than that, there isn't a ton of downside from avoiding high beta assets and investing in low beta assets. Provided you manage risk responsibly, this pricing anomaly is an important thing to have in your playbook.

Conclusion

The low volatility anomaly gives investors a nice way to boost their returns, either by allowing them to have a higher equity allocation in their accounts or by using leverage on a diversified portfolio to get significantly higher returns for less risk than a traditional stock-picking portfolio or ETF portfolio. Hopefully, being exposed to some of these new concepts can help you think of ways to increase your wealth and sleep better at night.

Another interesting nugget I dug up from my research – investors in Las Vegas seem to be the least diversified and get the some of the poorest risk-adjusted returns of US investors. Go figure! Someone should do a comprehensive study on this, but I would speculate that investors in New York City achieve the highest risk-adjusted returns for a variety of reasons, including working and being educated in high finance and having superior access to information.

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Disclosure: I am/we are long VYM, IVV, VYMI. 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.