Tag Archives: time

Not Your Father’s Low Volatility Strategy

By Fei Mei Chan Low volatility strategies were a popular and growing category in 2015, and if the first several days of 2016 are any indication, it wouldn’t be surprising to see their popularity continue in the New Year. That said, the topic of low volatility investing often comes with much discourse. A frequent argument is that a low volatility tilt is very similar, if not synonymous, to a bet on a small number of sectors or industries. In its 25-year history, the S&P 500 Low Volatility Index has often had high concentration in low volatile sectors – most frequently Utilities, Financials, and Consumer Staples. The index seeks out the least volatile stocks – with no sector constraints – so having large positions in sectors with relatively lower risk is not surprising. However, there’s more to the low volatility story than a sector bet . As an exercise, we produce a hypothetical low volatility portfolio whose sector weights match those of the S&P 500 Low Volatility Index but whose sector returns match those of the complete S&P 500. The hypothetical results tell us to what extent Low Vol’s results come from sector tilts alone, vs. stock selection within sectors. As shown below, over the last 25 years, the hypothetical portfolio’s standard deviation was between those of the S&P 500 and the S&P 500 Low Volatility Index. Being in the Low Vol’s sectors during this period accounted for more than two-thirds of the total volatility reduction achieved by the S&P 500 Low Volatility Index. In the same period, the return increment attributed to being in the “correct” sector was only 24%. More than three-quarters of Low Vol’s outperformance is idiosyncratic to its stock selection methodology. We’re not alone in arguing for the existence of the low volatility effect independent of sector impacts. Baker, Bradley, and Taliaferro , in decomposing the low risk anomaly, found that stock selection contributed to higher alpha, while the contribution from industry selection was negligible. Asness, Frazzini and Pedersen concluded that even holding the industry effect neutral, low volatility bets exhibited positive returns. The implication of all this research is that a sector tilt can’t account for all the performance differentials of low volatility. To assume that the two strategies are synonymous is to leave something on the table. Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

2016 Investment Strategy With ETFs: Part 2

As we saw in Part 1 of this series , ETFs have been very popular. Understanding the trends in this area is helpful in being able to select ETFs in the right way and for the right purposes. This second part of the series will continue the discussion to understand ETFs in greater detail so that investors can make better choices. One of the important predicted changes is that institutional investors are likely to become more diverse. This will be seen on a global scale. Active ETFs Active ETFs are one area that many industry pundits believe will be the way of the future. As outlined by PWC (2013) : “After a slow start, active ETFs are picking up steam and are likely to become major drivers of a wider range of uses and greater share of wallet across a more diverse client base.” It is believed that this will create challenges in a range of areas, such as in the need for innovative approaches to the regulations associated with portfolio transparency. This has held back active ETFs until now. Additionally, it is not believed that everyone will benefit from active ETFs, and there is unlikely to be a broad-based move away from so-called “style box investing”. ETFs’ Pros and Cons It is thought that ETFs are going to continue to experience some issues as they grow and develop. Some of the problems that have been outlined include performance tracking problems, trade settlement and liquidity. Regulatory challenges, operational risks and poor technical understanding are also likely to hold back demand in some areas. Nonetheless, overall it is anticipated that ETFs are going to have a critical role in the asset management industry in the medium term. It is considered by PWC to be unlikely that ETFs will experience a slowing up of growth or even a reduction in growth in the short to medium term, as they are still very popular. Other changes in this area are likely to include increased customisation. Looking at the changes to ETFs from a different perspective, The Wall Street Journal (2013) asked experts in this area what they think . Like PWC, the Journal documents the increased likelihood of actively managed funds. While to-date these have not done particularly well in attracting investment, it seems this is likely to change in the future. Other projections for this industry include an increase in competition in this area. Some worry that ETFs may be too popular, and that there is too much chopping them around. It is thought that as a result of this, there is potential for some consolidation in this market. There were worries among some of the experts that there could be an increased likelihood of failure of new ETFs produced. The problem is perceived to be that while some of the products have big names behind them and will be able to achieve critical mass, others definitely do not, and these may struggle to attract investment. Some believe that these funds will start looking quite a bit more like managed funds in the future. Investment Strategy It seems that ETFs are here to stay, and their popularity continues to increase. This means that an ETF strategy is a useful component in any investment approach. The strategy used needs to consider the increased number of ETFs worldwide. It is suggested that there are several approaches to make money from expertise with ETFs. One of the suggestions is creating opportunistic products that are based around marketplace events. A second is looking at them as the base for packaged solutions, for annuities or allocation funds. A third is to go down the actively managed route, taking outcome-focused strategies that use ETFs. A final option is looking back and creating products that are sold in an ETF format instead. In doing this, the asset manager needs to understand the ETF system and the opportunities faced. This means also being able to see how distribution platforms and databases can be used. It also involves looking at the ways that investors can be educated, so that people understand what ETFs are and the value that they bring to the table. Differentiating is considered to be particularly important in attracting attention.

How To Prepare For Volatile Markets

The last few years have been a relatively calm period for the US stock market, with few of the large swings that characterized markets during the financial crisis and the subsequent few years. But if the start of this year is any indication, 2016 may be more turbulent. What should you do with your investments to protect yourself from that possibility? The answer might actually be “nothing.” The first few days of a year don’t necessarily predict how the rest of the year will turn out. And larger market moves don’t necessarily mean you should make any changes to your portfolio. Markets go up and down all the time, and taking no risk with your investments would mean you wouldn’t have the chance to achieve more than meager returns. But if you are worried about market volatility, there are a number of ways to try to combat it, some more advisable than others. One way to try to protect yourself is to directly bet on volatility so that you’ll profit if markets become more tumultuous. These types of bets typically involve complex financial products such as options or exchange-traded products based on an index of stock market volatility. While betting on volatility can work in the short term if you guess correctly, it’s generally a terrible long-term strategy. For example, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ), one of the exchange-traded products tied to volatility, has lost more than 99% of its value since early 2009. Unless you fully understand how these types of products work and the unique risks involved, betting directly on volatility probably isn’t a good idea. A second way to try to counteract stormy markets is to shift some of your stock allocation into “low-volatility” funds. These investment products have proliferated in recent years and hold stocks that historically have had been less volatile. These funds can indeed help reduce the impact of choppy markets, but there’s no guarantee that the stocks that historically bounced around less will outperform during any one future period of stock market instability. It’s also worth considering that some of these funds may shift your exposure not just toward less-volatile individual stocks, but also more broadly to less-volatile market sectors (such as utilities). Changing your sector exposure isn’t necessarily good or bad, but it’s something to be aware of if you’re thinking about low-volatility funds. Perhaps the simplest way to prepare for market turbulence is simply to shift some of your allocation in higher-risk investments (such as stocks) into lower-risk investments (such as bonds). Shifting your allocation doesn’t mean completely abandoning stocks – you don’t want to make it impossible to achieve your financial goals if stocks actually perform well – but rather, making slight adjustments so that you’re more comfortable with how your portfolio is positioned. After all, if the possibility of more volatile markets is keeping you awake at night, that might be a sign that your portfolio isn’t properly calibrated to your risk tolerance.