Low volatility solutions for volatile times | #FinanceFridays
After several years of relative market stability, the recent spike in volatility sent a chill through markets in September and October. While sharp downswings in the markets are never comfortable, some investors are able to tolerate the volatility. However, for those investors who determine they have a lower tolerance for risk than a typical equity allocation requires, but still need equity exposure to meet their investment objectives, low volatility strategies can offer an effective solution.
Low volatility investing
Low volatility strategies aim to provide some downside protection when investing in equities, while retaining the ability to participate in rising markets. These strategies can be considered within the equity allocation of a portfolio to help generate superior returns versus bonds, while reducing the overall risk profile of the portfolio relative to equities alone.
TD Asset Management was the first to launch a low volatility fund in Canada and is a leader in this segment
Low volatility strategies tend to have a higher weighting in dividend- paying, non-cyclical stocks in sectors such as utilities, health care and consumer staples. These strategies typically exhibit a value style that—as studies have shown—tends to outperform a growth approach in the long run. Collectively, these exposures tend to result in a portfolio that is less sensitive to market fluctuations.
All low volatility strategies are not created equal
While low volatility strategies tend to demonstrate common characteristics, investors should keep in mind that differences can exist between solutions. For example, some low volatility solutions are constructed using stocks that have demonstrated the lowest volatility over a specified period of time with little regard to other elements of portfolio construction, such as sector or regional diversification. The PowerShares Canadian Low Volatility Index Fund has a significant relative overweight to Canadian financials with approximately 56% exposure versus the S&P/TSX Composite Index of approximately 35% (Source: Morningstar® Direct, as at September 30, 2014).
It is important to note that while targeting lower volatility is a compelling investment objective, there is no guarantee that this goal will be met in all time periods. In addition, investors should be aware that during periods of sustained rising equity markets, low volatility strategies are expected to lag the performance of a broader market.
Low volatility mutual funds
For investors seeking a low volatility fund, TD Asset Management (TDAM) is a leader in this segment and was the first to launch a low volatility fund in Canada. TDAM currently manages four low
volatility strategies: TD Canadian Low Volatility, TD U.S. Low Volatility, TD Global Low Volatility and TD Emerging Markets Low Volatility. In addition to TDAM’s offerings, Royal Bank of Canada offers the RBC QUBE Low Volatility funds and Mackenzie Investments launched the Mackenzie U.S. Low Volatility Fund in April of this year.
For those investors approaching or currently in retirement, and who are looking for a fund-of-funds solution as a core building block for their portfolio, the TD low volatility series of funds can be found in the TD Retirement Portfolios. These portfolios use a combination of low volatility equities and a flexible fixed income approach that focuses on corporate bonds. They also hold the TD Risk Reduction Pool, which employs both equities and options to help limit the portfolios’ downside while seeking long-term capital appreciation.
Low volatility Exchange Traded Funds (ETFs)
In addition to actively managed low volatility funds, investors can gain access to North American and international low volatility strategies using passive ETFs. Broadly speaking, ETF providers use one of two key ways to construct low volatility portfolios. One is to rank stocks in a given universe based on their past volatility. For example, the BMO Low Volatility Canadian Equity ETF screens the 100 largest and most liquid equity securities in Canada to construct a portfolio of the 40 least market sensitive stocks based on their sensitivities to market movements. Similarly, the First Asset MSCI Canada Low Risk Weighted ETF re-weights all the constituents of the market capitalization weighted MSCI Canada Index such that stocks with lower historical return variance over a three-year period are given higher weights in the portfolio.
Low volatility strategies can offer an effective solution for investors with a lower tolerance for risk who need equity exposure to meet their investment objectives
Despite being relatively more complicated, we prefer the MSCI Minimum Volatility Indices’ methodology, which uses a proprietary methodology to optimize a parent MSCI index for the lowest absolute volatility subject to certain rules. These rules include limits on index turnover, as well as maximum and minimum weights for stocks and sectors. For example, the iShares MSCI USA Minimum Volatility Index ETF tracks the performance of the MSCI USA Minimum Volatility Index. This index measures the performance of the top 85% U.S. listed equity securities by market capitalization that have lower volatility relative to the companies included in the parent MSCI USA Index.
Understanding your goals and risk tolerance, and selecting investments that suit your circumstances are key to achieving your investment objectives. If periods of volatility make you uneasy, consider adding low volatility strategies as part of the equity allocation in your portfolio.
THE LAST WORD
Volatility in perspective
Scott Booth, CFA
Markets have tread a steady upward path for quite some time and the recent divergence from that path has resulted in some discomfort for many investors who have grown accustomed to the positive trend. While the recent turmoil in markets has led many financial pundits to make claims that volatility is back, the reality is that the market has been experiencing much milder swings than it has during many periods since the turn of the millennium.
A little thing called recency bias
The human brain is one of the most fascinating, interesting and incredibly complex machines known to exist. From walking down stairs (which in itself is an extremely complicated act) to juggling knives to, well, studying themselves, our brains perform tasks that are nothing short of a miracle. Unfortunately, when it comes to investing, they (and you) are not as rational as you think.
Here’s the problem: we are creatures of habit. We grab the milk out of the fridge in a well-practiced manner, we take the same route to work, we eat and sleep at a certain time, and we even sit in a certain way when we read. The reason is simple, our brains are smart. They outsource their neuron labour so they can focus on more complex (new) issues at hand. This habitual behaviour allows our brain to reduce the amount of information it has to store, i.e., we don’t need to remember the route we took to work three months ago; we just need to remember yesterday. Unfortunately, the brain’s preference for remembering and recalling only the most recent occurrences biases our thinking, creating a contextual drift commonly known as the recency bias.
The recency bias is pretty simple. We’re inclined to use our recent experience as the baseline for what will happen in the future. This bears repeating: you are naturally inclined to use your recent experience as the baseline for what will happen in the future. This means that the context we apply to our thinking at any given moment can be thought of as a recency-weighted sum of previous experiences or memories. This works fine for our everyday lives but when it comes to investing, you can see how it can cause problems. The most obvious of which is that it blinds us from the big picture.
So what can you do about it? First, be aware. The recency bias is sub-consciously marinating on the back burner. Bringing it to the front (consciousness) allows us to figure out how it works. Once you know that, you can not only compensate for its shortcomings but use it to your advantage. For example, we tend to remember the last item on a list, or the last thing we hear or read. Why not be strategic about it? Think long term.