We hosted two experts from S&P Dow Jones Indices for an in-depth conversation about low-volatility as an investment factor. In this final installment of the interview, we discuss different advisor views on low volatility, how it pairs with other factors and how it can be used in portfolios.
I spoke with Craig Lazzara, Global Head of Index Investment Strategy and Shaun Wurzbach, Global Head of Financial Advisor Channel Management.
Part one, Q&A: Understanding low-volatility investing, introduced the foundations of low volatility, how it was created and how it works. Part two, Q&A: Are all low-volatility strategies the same?, covered the two common approaches to low-volatility index construction – minimum variance and unconstrained.
The following is the final part of our conversation.
Chris: How should we think about low volatility in terms of overall portfolio construction?
Shaun: Well, there is some discussion among advisors about whether low volatility is designed as a tactical tool or a core tool. It is a strategy index and some argue that a strategy index, by the nature of its selective design, can never be part of a core holding. My view is always that all decisions depend on how advisors are trying to achieve client objectives, and this is certainly true of how they use indexing and ETFs.
There are a number of ways that we see advisors using low volatility. Let’s take the Canadian or the U.S. market; either one would apply. In a tactical approach, an advisor may have a view that there’s going to be volatility that will lead to capital losses in their home equity market. So they decide to sell off some of that core position, use the proceeds to buy an equal amount of low volatility, and the low volatility acts as a buffer against that capital loss. They would hold that position for as long as they view the market as being in some distress.
A core use we’re seeing is that advisors believe low volatility is an anomaly and, in fact, by holding that exposure over a long period of time, they might actually outperform the benchmark. Then it becomes what an economist might call a free lunch. If they believe that with less volatility they can have more return, they would feel that’s a more prudent decision. If I have the ability to lower risk in my client’s portfolio and have a higher return, then it’s my duty to evaluate that and use it.
Those are two simple ways of seeing both the tactical and strategic use for low-volatility strategies, which we see advisors working with all the time.
Chris: Low-volatility indices are sometimes not viewed as core holdings. How and why should they be considered as core portfolios?
Shaun: I think that many advisors do think of it as core because of the outcomes they feel it can deliver. Equity exposure with outperformance over time is very important to them and that’s what the historical data suggests it should deliver. It ties in with an advisor’s purpose that they have to protect capital. That’s the number-one thing that they have to do. Growth on top of that is appreciated by the client, but one of the primary goals that they have within their investment strategy is to protect capital.
Craig : One way to think about what low volatility does is summed up in what I call the two P’s: protection and participation. Relative to the S&P/TSX Composite, or whatever the parent index is, low-volatility portfolios give you protection on the downside – that’s not perfect protection, you can still lose money, but they will tend to go down less when the market’s down – and they participate, not fully, but they will participate on the upside. Low volatility tends to truncate or attenuate returns in both directions, and there are many investors for whom that pattern is desirable.
Shaun: It’s important to understand that most advisors don’t see it as an all-or-nothing trade when they’re thinking about low volatility. You might think it’s a binary decision to be either all in low volatility or all in the parent index. But, instead, we see most advisors have a tilt, and I think that lines up with their clients’ risk tolerance or how they view volatility going forward. It is not uncommon to see them adjust that depending on their views. They may always hold low volatility, but at the same time they’re holding that benchmark, and it’s a percentage play. It might be 30/70, it might be 60/40, but they are able to keep that dynamic, and that’s what we are typically seeing.
Chris: Looking at low volatility alongside other investment factors, are there other factors that pair well with low volatility in portfolio construction?
Shaun: I think a dividend strategy is the first thing that advisors would combine with low volatility. They feel like there’s a bit of downside protection in companies that have traditionally paid an increasing dividend over time.
The other thing that might work well with low volatility is a quality strategy. When advisors are skeptical about the equity market they tend to trade up to quality. This is something that they’ve been doing for decades. If you talk to older investors, they say when times get tough the investor goes into blue chips, and that was a quality statement. When people were concerned about risk they would go to the companies that they thought were strongest within the marketplace. So in addition to dividends, I think quality is a factor that many advisors would combine with low volatility.
Craig: I’ll give you a third, if I may – momentum. If you look at the correlation of excess returns for low volatility versus yield, versus quality and versus momentum, one of the lowest correlations you find is between momentum and low volatility. This means that the combination of those two can have some interesting risk/return properties. A 50/50 combination of low volatility and momentum, it’s not quite as good on the downside because momentum typically is not a defensive strategy. But when the market’s up, the lag that low volatility would have is diminished a lot because of the momentum factor.
Chris: What do you think prompted the appetite for low-volatility among Canadian advisors?
Shaun: Within the Canadian market, we thought that advisors would appreciate tools that stand as gears in between their traditional choices. For example, in the past, for Canadian advisors concerned about the Canadian equity market, their choice would have been to move from equities to fixed income, or from equities to cash or some combination of the two – all pretty stark choices. We see advisors adopting low-volatility strategies as another choice in terms of how they manage risk. Essentially, they could position it between equity exposure and fixed income or in between equity exposure and cash. They can now start to tilt depending on their view and depending on their clients’ risk tolerances. Having another tool in the kit allows them to have more choices or more gears to operate.
I want to thank Craig and Shaun for joining us for this conversation about low-volatility investing. I hope you find it valuable. If you have any questions, please feel free to leave them for us in the comment box below.