When the economy tanks, most people don’t rush to spend the cash left in their wallets on lottery tickets. So, why is “more risk equals more return” still such a common investing misconception?
It’s been more than six months since the world has been sick with COVID-19 and people everywhere still have the same unanswered questions: exactly when will we have effective treatments and a vaccine to protect from the coronavirus? Once that happens, when will the economy truly rebound?
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Even more, with the November elections less than two months away, what happens next? Consider that since 1932, “an incumbent president has never failed to win re-election unless a recession has occurred during their time in office,” according to research by J.P. Morgan Asset Management. But, historical precedence or not, no one knows what the outcome will be.
Even more, it’s quite possible that because of the increase in mail-in ballots due to the coronavirus this election year that election results could be slow to come in. If the delayed results of the Bush vs Gore election have anything to teach us, low volatility factors could fare particularly well, according to Style Analytics.
What will happen with it all and what will it mean for the world and its financial markets? No one really knows.
In an economy hinging on lots of unknowns, it’s no surprise that more and more investors are seeking safe, predictable investments. That’s good news for minimum volatility funds. While they lack the fanfare of a big lottery ticket win or a stock sell off, they tend to perform better than their counterparts over the long term.
Here’s why now is the perfect time to consider minimum volatility investments.
What is minimum volatility?
Many investors are trying to weather the uncertainty of the world and the markets, leading them to minimum volatility strategies. “Minimum volatility ETFs (commonly referred to as “min vol” ETFs) attempt to reduce exposure to stock market volatility,” according to Fidelity Investments.
Minimum volatility is considered a defensive factor that’s especially effective over the long-term. According to research by BlackRock, “the longer the market drawdown, the higher likelihood for outperformance of minimum volatility.” One reason for this is that stocks of companies that have predictable earnings tend to exhibit low-volatility. That makes low volatility a positive investment factor.
The tradeoff for steady returns in down markets, however, is that when markets are performing well, returns are typically average. This is known as asymmetry.
Note, however, that minimum volatility indices are different from low volatility indices. Although they are similar, it’s worthwhile to describe both.
“Low volatility indices rank constituents by their trailing volatility and select the least volatile stocks, whereas minimum volatility indices use an optimization-based approach to construct the least volatile portfolio,” according to the S&P Dow Jones Indices Indexology Blog. This means that low volatility indices include strictly low volatility stocks, which is different from minimum volatility indices that may contain highly volatile stocks.
Research on low volatility goes as far back as 1972 with the release of the paper “On the Evidence Supporting the Existence of Risk Premiums in the Capital Market,” written by Robert Haugen and James Heins, which examined the period from 1926 to 1971. The paper concluded that “over the long run stock portfolios with lesser variance in monthly returns have experienced greater average returns than their ‘riskier’ counterparts.”
Research on low volatility investing didn’t stop in the seventies. For example, according to a research paper published in 2019 by the S&P Dow Jones Indices: “The low volatility anomaly challenges the conventional wisdom about risk and return—low volatility stocks, by definition, exhibit lower risk, but they have also outperformed their benchmarks over time. This phenomenon is observed universally across the globe.”
The S&P Dow Jones Indices paper emphasizes that since the 2008 financial crisis, low volatility has become an increasingly important factor for investors.
Investing in minimum volatility funds
There is empirical evidence that low volatility investing works for equities, as well as US Treasury bonds, corporate bonds and foreign exchange, according to IPE. “While low-volatility strategies will lag market returns during bull markets, the idea is that their outperformance during bear markets more than compensates.”
Minimum volatility funds and ETFs typically invest in a balanced portfolio of stocks that displays lower overall risk to the broad market, tracking indexes that are intended to provide lower-risk. This category of funds and ETFs has become an increasingly popular and straightforward way to diversify to limit risk exposure. While minimum volatility investments do not guarantee returns they do make for a bit of a smoother ride on the way to more predictable returns.
Today there are a number of min vol funds and ETFs to choose from. A search on Magnifi suggests that those investors interested in adding a minimum volatility angle to their portfolio have a number of different options available, including those shown below.
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