The stomach-wrenching volatility and rising correlations over the past several years have led many to begin questioning some core principles of modern portfolio theory such as the benefits of portfolio diversification and investing for the long term. For the record, our stance on diversifying assets and investing for the long haul remains unchanged. In this article, however, we'll focus on another widely accepted tenet of investing that many in the industry are (justifiably) beginning to question: higher risk equals higher returns.
In their recently released study titled Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen present a compelling case with empirical evidence suggesting that high beta is in fact associated with low alpha. Their conclusion makes sense intuitively. The idea that in order to earn higher returns investors must take on higher risk has become so deeply engrained in our minds that investors tend to indiscriminately bid up the prices of higher-beta assets in hopes of "getting rich quick," while often overlooking opportunities in less exciting, lower-beta assets.
With the Oct. 21 launch of BMO Low Volatility Canadian Equity ETF ZLB, Canadian ETF investors have access to a product designed to exploit the low-volatility anomaly. Now, investors of all stripes can benefit from the somewhat puzzling phenomenon that, over the past fifty years, the least volatile stocks have performed about as well as the most volatile stocks, but with far less risk.
Researchers have come up with several explanations as to why low-volatility stocks post such great risk-adjusted performances. The most convincing involves leverage aversion. Investors who target above-market returns may be unwilling or unable to use leverage to reach their expected-return targets. By resorting to volatile stocks (more precisely, high-beta stocks) which theoretically should outperform less-volatile stocks, they hope to earn above-average profits. Ironically, their collective bet on high-beta stocks leads to their systematic overpricing and consequently low risk-adjusted returns.
We think there's ample evidence that this market inefficiency is real. However, investors should keep in mind that low-volatility strategies can underperform during bull markets such as the one experienced in the 1990s. ETFs like ZLB will likely produce great risk-adjusted returns over decade-long time horizons. Such a fund could serve as the nucleus of an investor's domestic stock allocation, but to fully benefit investors should be willing to underperform during extended bull markets.
BMO Low Volatility Canadian Equity ETF is reasonably priced with a management fee of 0.35%. The fund's methodology is admirably simple and transparent; it holds a portfolio of the 40 lowest beta stocks selected from the 100 largest and most liquid securities in Canada. Recall that beta is a measure of a security's sensitivity to market gyrations. So for example, a beta of 0.70 means that for each 1% move in the Canadian stock market ZLB will move in the same direction by 0.7%. Lower-beta stocks take priority in this fund, as constituents are weighted by the inverse of their one-year betas (1/beta). Sectors are capped at 35% and single securities are capped at 10% of the overall portfolio. The fund is reconstituted and rebalanced semi-annually in June and December.
In terms of sector allocations, ZLB provides fairly balanced exposure, with financials having the largest position at about 24% of total assets. That said, investors should keep in mind that compared to the broader Canadian market, the fund significantly overweights the classically defensive sectors that one would expect from a low-beta strategy: consumer staples, telecom services and utilities. Conversely, it also substantially underweights the most economically sensitive sectors: industrials, materials and technology.
The table below highlights ZLB's sector allocations versus the broader domestic market. Prospective investors should closely consider this information before deciding whether to use the fund as a core equity holding or as a complementary overlay.
|ZLB sector allocation (%) relative to broader Canadian market|
|Data as of Nov. 3, 2011|
BMO's ZLB is the first, and currently the only fund of its kind that trades in Canada. Investors who are attracted to low-volatility equity strategies could also consider some U.S.-listed ETFs that follow similar methodologies (though ZLB is the only fund that specifically tracks Canadian stocks).
The most popular fund in the group is PowerShares S&P 500 Low Volatility SPLV, which launched in May of this year with an expense ratio of just 0.25% and has already amassed nearly US$600 million in assets. The fund holds the 100 stocks in the S&P 500 that have had the lowest volatility over the past year, weighted by the inverse of their volatilities (as measured by standard deviation). In practice, the fund ends up being close to equal-weighted, because stocks' individual volatilities tend to be less divergent than their market capitalizations. SPLV reconstitutes and rebalances quarterly.
In mid-October, iShares launched its own suite of global low-volatility ETFs that undercut SPLV in price, including iShares USA Minimum Volatility Index USMV, iShares MSCI EAFE Minimum Volatility Index EFAV, iShares MSCI Emerging Markets Minimum Volatility Index EEMV and iShares MSCI All-World Minimum Volatility Index ACWV, which levy expense ratios of 0.15%, 0.20%, 0.25% and 0.35%, respectively. The four iShares funds reconstitute and rebalance semi-annually.
Finally, Russell ETFs also offers a suite of low-volatility and low-beta equity ETFs that track U.S. large-cap and small-cap indexes. Its large-cap ETFs, Russell 1000 Low Volatility LVOL and Russell 1000 Low Beta LBTA, charge 0.20% per annum and select the lowest volatility and beta stocks from the index until the fund represents 35% of the total market capitalization of the Russell 1000 Index. The small-cap ETFs, Russell 2000 Low Volatility SLVY and Russell 2000 Low Beta SLBT, charge 0.30% expense ratios and follow the same strategies as their large-cap siblings, targeting 35% of the total market capitalization of the Russell 2000 Index. Each of the Russell ETFs reconstitutes and rebalances monthly, which will result in much greater portfolio turnover.