Back in 1981, Wynton Marsalis burst onto the scene as a trumpet player followed soon after by his brother Branford --- then came Delfaeyo. At about that time, a New Yorker cartoon featured a small boy dashing into the living room yelling, “They just discovered another Marsalis brother!” It turned out to be Jason Marsalis on the drums. It all reminds me of my experience of financial products. Just when you think nothing else could be invented, something new enters the firmament.
In the most recent case, it has been the growing proliferation of so-called “low volatility” funds. They received my attention after reading an article in “Morningstar” magazine in which researcher Alex Bryan compared low volatility performance to that of conventional balanced funds combining stocks and bonds.
By way of explanation, volatility of a fund is measured by standard deviation. One standard deviation is the range within which gains and losses will fall about two-thirds of the time. Two standard deviations is the range within which results will fall 95 percent of the time (all but one out of twenty years on average.)
For a simple example, a low volatility index fund invests in the 100 stocks of the S&P 500 that have the lowest volatility compared to the remaining 400 companies. The attraction has always been that, during many periods, these stocks have actually outperformed the market averages. “Slow and steady wins the race” especially when dividends are re-invested. If a low volatility fund can offer less volatility than even a typical balanced fund while creating higher expected earnings, why not go for it?
Over rolling ten-year periods, an all-stock portfolio generally earns about 10 percent per year with one standard deviation of 17 percent. Folding bonds into the mix for up to one-third of the portfolio brings the expected return to 9 percent, but reduces the standard deviation to 12 percent creating less volatility.
The Morningstar analysis showed that choosing a low volatility stock index offered less volatility than selected balanced stock/bond allocations while generating between one and two percent more in annual returns.
Furthermore a Wall Street Journal article (April 6, 2014) entitled “High Hopes for Low Volatility Funds” pointed out that these funds should NOT be expected to outperform funds that incur more risk. The fact that they have been doing so is referred to as the “low-volatility anomaly.” Boring funds should be winners during some periods of an economic cycle, but they shouldn’t have been outperforming since the early ‘70’s as one study shows.
To illustrate the reason for the “anomaly,” small companies, as a group, have outperformed large companies by about 2 percent per year going back to the 1920’s. This is a reflection of the “risk premium” at work. It’s the “invisible hand” of economic forces rewarding those who can live with higher levels of volatility/risk which come with the territory in the world of small companies. If that invisible hand hadn’t proven itself to be self-evident, nobody would have any incentive to take more risk (setting aside the fact that some investors are just dreamers, gullible, and lacking in analytical skills.)
So thanks to the anomaly of low volatility stocks swimming successfully upstream, they have been doing comparatively well while offering exposure to the market with less risk. They may have been doing too well. The concern today is that the prices of stocks chosen by low volatility funds have responded to the demand to the extent that they are no longer bargains. However, for those interested in considering the strategy, there are about 40 different funds and ETF’s to satisfy your craving for what could be a better mousetrap offering higher returns with less risk. Check it out.