The case for low-volatility equity funds

Christopher Davis: I'm Chris Davis with Morningstar.ca. In the wake of the 2008 financial crisis, investors have sought lower-risk ways to invest in stocks. Not surprisingly, fund companies and ETF providers have stepped in to fill the gap.

Here to talk about these sorts of strategies is my colleague, Vishal Mansukhani. Vishal, thanks for joining me?

Vishal Mansukhani: Thanks for having me, Chris.

Davis: Vishal, there is a lot of academic research out there demonstrating that lower-volatility or lower-risk stocks outperform higher-volatility stocks over the long haul. Traditional financial theory is that risk and reward are tied: the more risk you take, the more reward you get. If this academic research is true, this throws financial theory out the window, so why may lower-volatility stocks outperform? At least what's the argument for that?

Mansukhani: Well, one way of looking at it is that a lot of the attention in the market is given to very popular stocks which are from flashy sectors like technology, and people tend to ignore some of the boring, low-volatility dividend-paying stocks. So because of their lack of attention, there is a possibility of outperformance.

Also, a lot of the low-volatility stocks tend to pay a stable dividend. That stable dividend adds a stability factor to the total return component of a stock. Because standard deviation is a measure of the fluctuations in magnitude of the total return, because the dividend adds a stability, the standard deviation is lower. So that's two reasons. Also, historical research on performance has shown that investors have not been compensated by taking on more risk and investing in higher-volatility stocks.

Davis: Now there might be some environments, where higher volatility stocks do outperform, and that's been the case recently with the markets rallying. What are the other sorts of environments where low volatility might not look so hot.

Mansukhani: Of course, so when markets are doing really well, high-volatility stocks will do well. But also when, for example, we talked earlier about low-volatility strategies investing in specific sectors, which pay high dividends. So these sectors...

Davis: …financials, utilities...

Mansukhani: Financials, utilities -- so a lot of these sectors also come with a lot of inherent interest-rate risk. So, perhaps in an environment of rising interest rates, low-volatility stocks may underperform given the exposure to interest rates of those sectors.

Davis: Since we're at all-time lows in interest rates, there is a potentially higher risk investing in low volatility now than versus the past.

Mansukhani: Right. Also the strategies of the ETFs and funds that invest in low-volatility stocks, they construct their portfolios with stocks that move inversely to each other. So when one stock is down, the other one might be up. But sometimes in extreme environments like that of 2008, all the stocks move in one direction -- down -- and that's when low-volatility stocks could underperform as well.

Davis: That would be kind of unfortunate because that's why you're buying these funds to be in with, right.

Mansukhani: Exactly. Also, all the strategies that invest in low vol stocks, there is a big component of looking at historical returns, historical price movements and things like that. But there is no guarantee that history will repeat itself. So that's the biggest factor suggesting that it may not perform as planned.

Davis: Now, there is more than one way to skin the low-volatility cat; one way is just that looking at historical volatility and investing in stocks that haven't been very volatile, and weighting them accordingly, can you talk just about this more backward-looking approach too.

Mansukhani: So the backward-looking approach takes into consideration the standard deviation of the stocks, how they've done in the past and how they've moved together in the past. They construct a portfolio using stocks that have had the lowest standard deviation and that have moved in different directions in the past. But there's also a forward-looking approach that adds a forward-looking component to that backward-looking analysis, which examines a company's fundamentals and perhaps that might be a better predictor of how a stock is going to perform in terms of price fluctuations in the future.

Davis: So in terms of fundamentals, we are talking about things like earnings or profitability, and so if a company has good earnings growth prospects and lowest historical volatility, they might be better than just looking at low volatility by itself?

Mansukhani: Of course, and funds like the RBC QUBE Low Volatility, those funds also look at balance sheet data, which again are a good indicator of how unstable or stable a stock is going to be in the future.

Davis: And so RBC is an example of the more forward-looking approach, who has the more backward looking, more historical data focused approach?

Mansukhani: So a lot of the ETFs have a backward-looking approach. The TD Low Volatility funds have a backward- looking approach, but also forecast statistically, but they rely more on historical price data. There are also -- the MSCI indices are also backward looking.

Davis: So, let's just get to the bottom line here. What should investors really expect from low-volatility strategies going forward?

Mansukhani: So investors should not expect tremendous outperformance from these strategies, but what they can expect is lower price volatility and lower fluctuations in their investment, in their wealth by investing in these strategies, because these strategies focus a lot more on reducing risk than generating outperformance.

Davis: So, clearly, here the moral of the story is, this is more about avoiding risk than earning big returns?

Mansukhani: Yes, precisely.

Davis: Well, thank you for all your insights, Vishal.

Mansukhani: Thanks for having me Chris.

Davis: I'm Christopher Davis with Morningstar.ca.