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A Low Volatility Portfolio Should Include More Than Low Volatility Stocks

John McClenahan, CPA, CFA

There are several ways to construct a low volatility portfolio. One way is simply to invest in a basket of low volatility stocks and call it a day. There are a growing number of ETFs that offer this approach. While straightforward and potentially useful as a tactical allocation, several potential negative “side effects” accompany the use of this method for long-term investing.

The first is that over time, the lowest volatility stocks are found in different sectors. And when you have a year like 2015, when the lowest volatility stocks were increasingly in two sectors – financials and consumer staples – you end up with a portfolio that is highly concentrated in these areas. For example, one ETF that promotes itself as a low volatility offering has seen its combined weighting in financials and consumer staples soar 18 percentage points in a year to nearly 60% of its portfolio. Clearly, if something were to cause either or both of these sectors to decline, the portfolio could suffer.

Another issue that plagues a portfolio of low volatility stocks is that, by design, the portfolio is overly exposed to one factor – low volatility! Things are great when this factor is doing well. 2015 was a strong year for low volatility stocks. Some people tend to think of momentum and beta as being almost synonymous. But unlike 2014, the momentum that drove the market over the past year was increasingly found in low volatility stocks. According to the MSCI Barra Global Equity Model (GEM)®, the correlation of the momentum and low volatility factors increased from -0.6 in late 2014 to +0.7 in late 2015.

5 Years Ended 12/2015

Past performance is no guarantee of future results. Source for data: MSCI Barra.

Additionally, valuations of these stocks look to be high and the trade seems to be very crowded. According to J.P. Morgan, the forward P/E multiple of low volatility stocks is 19x compared to 15x historically with close to $1 trillion invested in low volatility strategies.

A Better Approach to Low Volatility Investing

Another approach to long-term, low volatility investing is through a portfolio that decreases volatility the “old fashioned way” – via active diversification. As John Calamos, Sr. mentioned in a recent investment commentary, while diversifying between stocks and bonds can provide lower volatility, a potentially better method is to include convertible securities. Carefully managed while taking into account company fundamentals, convertibles provide equity participation with less exposure to the downside given the securities’ stock-bond hybrid nature. This approach is designed with a structural asymmetry that works to mitigate downside risk and potentially benefits from volatility.

Such a portfolio can provide a level of volatility that is roughly the same as that of many leading low volatility products. And it can offer diversification and equity participation in many sectors and areas of the global stock market – not just low volatility stocks. Volatility is controlled at the portfolio level, not the individual stock level.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries. Convertible securities entail interest rate risk and default risk.

Price-to-earnings ratio (P/E) is a valuation ratio of a company’s current share price compared to its per-share earnings. Forward P/Es are based on forecasted earnings. Indexes are unmanaged, not available for direct investment and do not include fees or expenses. A common measure of volatility, beta measures how much of an investment’s performance is attributable to market-wide factors (such as a rising stock market). An investment that goes up or down as much as a broad market measure has a beta of 1. An investment that captures only half of the market’s movements would have a beta of 0.5.

The MSCI Barra Momentum factor explains the return differences of stocks based on their relative performance over the trailing 6-12 months.

The MSCI Barra Volatility factor explains returns associated with high (low) volatility stocks based on their historical standard deviations and cumulative ranges.

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