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Wheels likely to come off the low-volatility bandwagon

While scholarly studies have concluded that low-volatility strategies lower risk and raise returns (in apparent violation of the axiom that higher returns require higher risk), their findings are before costs

Brian Jackson/Photos.com

Many years ago, academic research found that low-volatility stocks generated a smoother ride while matching or outperforming the market. More recently, a flurry of media articles and a dozen or so new exchange-traded funds (ETFs) in the U.S. and Canada have channelled billions of dollars into these stocks. Alas, this looks like another investment fad destined to go off the rails.

While scholarly studies have concluded that low-volatility strategies lower risk and raise returns (in apparent violation of the axiom that higher returns require higher risk), their findings are before costs. Include them and a different picture emerges. Of note, a 2012 paper, "The Limits to Arbitrage Revisited: The Low-Risk Anomaly," has discovered that the required rebalancing and trading of less-liquid stocks imposes costs that eat up most of the premium.

In addition, low-volatility ETFs charge higher management expense ratios (MER). For example, the PowerShares S&P 500 Low Volatility ETF in the U.S. has an annual MER of 0.25 per cent, versus 0.07 per cent for the iShares S&P 500 ETF.

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Perhaps more damning than transaction costs is that publicity and new ETFs have helped push up prices. According to Richmond, Virginia-based RiverFront Investment Group, low-volatility stocks are 30 to 40 per cent overvalued in 2013. As Benjamin Graham noted in The Intelligent Investor, risk is linked to price paid. The more investors overpay, the more likely returns will fall short of expectations.

Volatility itself has been affected by this sudden interest. Crowds make financial markets more volatile, so ironically, this asset class will likely display wider fluctuations going forward, more in line with market norms. Even if the historical pattern of 20 to 30 per cent less variability prevails, there'll still be big drop during the next crash. In early 2009, for example, low-volatility ETFs would have tumbled by 25 to 35 per cent.

Not that many investors really need these low-volatility strategies, anyways. If you have high exposure to dividend stocks and/or the utility, consumer-staple or regulated industries you already have low volatility built into your portfolio.

Larry MacDonald is a retired economist who manages his own portfolio and writes on investing topics. He tweets at @Larry_MacDonald

READERS: Do you rely on low-volatility products like ETFs, or do you look for specific sectors or utility-like stocks?

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