Overlooked qualities

Not all low-volatility strategies are the same

As global equity markets continue to convulse, the perils of tracking a capitalization-weighted benchmark index have been laid bare once again.

A benchmark doesn’t seek to boost an investor’s exposure to undervalued securities, nor is it able to tap into other qualities overlooked by the market, such as lower volatility. The benchmark simply follows the herd.

Many investors build their portfolios with strategies that simply track the benchmarks. But investing isn’t about achieving average results; it’s about achieving goals.

Many investors may be hoping to reduce the volatility of their portfolios, but simply holding cash could jeopardize many investment plans.

A central tenet of finance is that investors seeking to reduce risk must accept reduced returns. Yet research suggests a portfolio of less-volatile stocks tends to provide a degree of protection during broad market declines while still participating in subsequent rallies.†

Investments that experience higher volatility have the potential to erode principal much more quickly than lower-volatility investments. With smaller losses in down markets, lowvolatility stocks don’t have to rise as much in value in order to recover their pre-downturn value.

Critical differences

Managing volatility is critical to investment success because volatility has the potential to wear away capital quickly. When choosing a lowvolatility strategy, it is important to consider the qualities that go into that strategy.

While some lowvolatility indices have sector constraints that prohibit them from straying too far from their parent index, the lowvolatility indices created by Standard & Poor’s (S&P) have the ability to dynamically rotate in and out of sectors as volatility dictates.

This allows S&P lowvolatility indices to adjust to market conditions in a more timely fashion, focusing exclusively on volatility, without arbitrary constraints.

For example, PowerShares S&P/TSX Composite Low Volatility Index ETF (TLV) employs an unconstrained rebalancing approach. By adhering to this methodology, TLV’s underlying portfolio began to reduce its energy weighting in September 2014 as volatility in the energy sector started to spike. By March 2015, the energy weighting in the portfolio had been completely eliminated.

An investment tracking the cap-weighted benchmark would have reduced its exposure to the energy sector but still held roughly 20% of assets in the struggling sector.

A constrained lowvolatility strategy, bound to deviate only slightly from the benchmark, would have maintained its exposure to energy, even as the sector continued to fall through the latter half of 2015 and into 2016.

Between June 30, 2014 and January 31, 2016, volatility spiked repeatedly. In August 2015, the Chicago Board Options Exchange Volatility Index (or VIX) hit levels not seen since 2011, the last previous period of major volatility.

During this period, TLV captured only 75% of the S&P/TSX Composite Index’s volatility, outperforming the benchmark by 18.29 percentage points and demonstrating the value of a low-volatility strategy.