Clean exposure to low-volatility U.S. stocks

PowerShares strategy provides a smoother ride than the S&P 500, but lacks sector constraints.

Alex Bryan 13 September, 2016 | 5:00PM
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The strategy of PowerShares S&P 500 Low Volatility (CAD Hedged) Index (ULV) and its U.S.-listed sibling  PowerShares S&P 500 Low Volatility (SPLV) is to aggressively pursue large-cap stocks with low volatility. This should offer a smoother ride and better risk/reward profile than the S&P 500 and most of its peers. But it doesn't constrain sector weightings or turnover, which can be high.

Each quarter, the strategy ranks the constituents of the S&P 500 by their volatility during the past 12 months and targets the least volatile 100. It then weights them according to the inverse of their volatility, so that the least volatile stock receives the largest weighting in the portfolio. This strategy implicitly assumes that recent volatility will persist in the short term, which has historically held. It does not consider how stocks in the portfolio interact with each other.

This is a fluid portfolio, but the holdings tend to enjoy more stable cash flows than the typical constituent of the S&P 500. These include names such as  Waste Management (WM),  AT&T (T),  Coca-Cola (KO),  Clorox (CLX) and  Johnson & Johnson (JNJ). Because there are no limits on sector weightings, the portfolio can end up with large sector bets. But these tilts can shift over time as levels of volatility among the stocks in each sector change. For instance, in June 2016, the exposure to utilities stocks stood at 22% of the portfolio, up from 3% a year earlier. During that same span, the exposure to financial-services stocks fell to 13% from 23%.

So far, the strategy has worked well. From June 2011 through June 2016, the portfolio exhibited about 20% less volatility and about 40% less market sensitivity than the S&P 500. And it outpaced the benchmark by 2.3 percentage points annualized during that time. This can be attributed to underweighting of the energy sector and stock selection in the industrial, consumer defensive and financial-services sectors.

Like other defensive equity strategies, this low-volatility approach is likely to lag during strong bull markets. Investors should not expect it to generate market-beating returns over the long run. But there is a good chance that it will offer better risk-adjusted returns than the S&P 500. Low-volatility stocks may be priced to offer attractive returns relative to their risk because their tendency to lag in bull markets can make them unattractive to benchmark-sensitive investors. The portfolio's defensive posture should help it weather market downturns better than its peers.

Fundamental view

Investors can always reduce risk by allocating a greater portion of their portfolios to less risky assets like cash or bonds. But this PowerShares strategy is likely to offer better returns than a market-cap-weighted stock/bond portfolio of comparable volatility, albeit with smaller diversification benefits.

Historically, less risky stocks (as defined by volatility or market sensitivity--beta) have offered better risk-adjusted returns than their riskier counterparts. This effect was first documented in 1972 by Fischer Black, Michael Jensen and Myron Scholes. They found that stocks with low sensitivity to market fluctuations (low betas) generated higher returns relative to their amount of market risk than stocks with high sensitivity to the market. Several other researchers found a similar pattern for stocks sorted on volatility.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favor riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at comparable or slightly higher valuations than the market.

The PowerShares strategy's narrow focus on recent volatility and frequent rebalancing allows it to effectively capture the low-volatility effect documented in the academic literature. But it can also lead to high turnover and introduce some indirect bets that investors may not anticipate. Turnover exceeded 50% in each of the past three years. In addition to large and fluid sector tilts, the portfolio's exposure to value stocks may change over time.

Not surprisingly, the portfolio has greater exposure to defensive sectors, such as utilities, health care and consumer-defensive stocks than the S&P 500. It also has greater exposure to the real estate sector and less exposure to more volatile sectors like energy, technology and financial services. While the strategy often takes large sector bets, it has limited exposure to individual names. The portfolio has a smaller-cap orientation than the S&P 500 because it does not weight its holdings by market capitalization. It also tends to favour firms with conservative asset growth, which can translate into higher free cash flows.

The strategy employs full replication to track the S&P 500 Low Volatility Index. Each quarter, S&P ranks the constituents in the S&P 500 by their volatility over the past 12 months and selects the least volatile 100 for inclusion in the index. It then weights these constituents by the inverse of their volatility, so that steadier stocks receive larger weightings in the portfolio. This approach is laudably transparent and it offers clean exposure to the low-volatility effect.

But because there are no constraints on sector weightings or turnover, the portfolio can end up with large sector tilts that change over time. And because it does not consider valuations in its selection process, the Canadian-listed and U.S.-listed ETFs can drift across the Morningstar Style Box. The portfolio currently nets out in large-blend territory but has exhibited a greater value tilt in the past. In contrast to some of their closest peers, the PowerShares ETFs do not take into account correlations among stocks, which can affect how the portfolio behaves.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
AT&T Inc20.99 USD1.84Rating
Clorox Co140.75 USD0.46Rating
Coca-Cola Co63.04 USD1.87Rating
Johnson & Johnson182.29 USD1.46Rating
Waste Management Inc150.31 USD2.12Rating

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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