Monday, April 18, 2016

Low Volatility Diversification

The Cost of Volatility for Investors
Low volatility investing is another form of factor-based investing. Typical investment factors include value, growth, equal weight, momentum, earnings, dividend and low volatility to name a few. All these investment strategies allocate their holding weights based on some metric other than market capitalization (size), which is how most of the traditional index mutual funds and Exchange-Traded Funds (ETFs) allocate their positions.

If investors can reduce the long-term volatility (price fluctuations) of their portfolios, then over the long run their portfolio returns will improve, all else being equal. In addition, there are behavioral benefits for investors if their portfolio growth from year to year is smoother versus exhibiting the ups and downs of a theme park roller coaster. 

So when you hear the term Compound Annual Growth Rate (CAGR) or Geometric Return, you are getting a return value that has been adjusted for volatility (standard deviation) as opposed to the non-risk adjusted average return which is more commonly reported in the financial press. The screenshot below of my retirement calculator provides examples of average return versus geometric return given increasing levels of return volatility.

Source: Koch Capital

As you can see from the example above, the cumulative effect of portfolio volatility is to slightly reduce total return given the asymmetric nature of compounding losses and gains. If you have no volatility of returns, like an annuity, then the two return types are equal. Please see this article if you are interested in a detailed discussion of volatility drag. Also, here’s the link to my flash-based retirement calculator if you want to experiment with your own return and volatility numbers.

Factor-Based Weighting to Compliment Traditional Passive Index Investing
The majority of Koch Capital’s portfolio strategies implement 80% traditional, low-cost, capitalization weighted index mutual funds and ETFs across global markets. The remaining 20% is generally more tactical and often incorporates factor-based strategies and non-correlated asset classes to reduce return volatility and improve diversification. You may hear this 80-20 structure referred to as the “core-satellite” approach to portfolio construction.

Within the low volatility asset class space, let’s look at four of the more popular strategies. PowerShares S&P 500 Low Volatility ETF (SPLV) was the first low volatility ETF to market, released on May 5th, 2011. This rules-based ETF samples the S&P 500 each quarter, selects the 100 least volatile stocks, and weights them by lower-to-higher volatility. This weighting strategy tends to cluster its allocation toward traditional low volatility industry sectors like utilities, consumer staples and healthcare.

Next, iShares MSCI USA Minimum Volatility ETF (USMV) is similar to its PowerShares cousin (SPLV), but starts with a broader US index covering large and mid cap companies, then optimizes based on volatility with additional constraints to make sure all industry sectors have at least some representation in USMV.

The iShares MSCI All Country World Minimum Volatility ETF (ACWV) uses the selection strategy similar to its sister, USMV, but starts with a global index that includes US, Foreign and Emerging Markets stocks.

Finally, the PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) combines both low volatility and high dividend screens to select its 50 companies for inclusion in SPHD, and rebalances on a semi-annual basis.
I’ve created the table below to compare the investment characteristics of our four low volatility ETFs along with the S&P 500 Index ETF (SPY) and the aggregate US bond index ETF (AGG). Please note that all returns listed in the two following tables include the internal fund management fee (E.R.) but are gross of any advisor fees, taxes and trading costs.

S&P 500 Index
Bond Index
US Low Vol
US Low Vol
Global Low Vol
US Hi Div & LV
Disclosure: Size is the Net Asset size of the fund or ETF as of 3/31/2016; Cor. is the 3 year correlation with SPY as of 3/31/2016; E.R. is the fund's expense ratio or internal management fee; Return is the average annual return from 3/31/2013 to 3/31/2016; Vol. is the 3 year historical standard deviation as of 3/31/2016; Beta is the fund's or ETF's 3 year historical beta from 3/31/2016 to 3/31/2016; Yield is the trailing 12 month yield as of 3/31/2016. All return values include internal fund fees, but are gross of advisor fees, taxes and trading costs. Source: Koch Capital, Quantext Portfolio Planner, HiddenLevers, Yahoo Finance

A quick scan of the table above shows that our four low volatility ETFs have more than $1 billion in net assets (good liquidity), relatively low expense ratios, and yields comparable or higher than the S&P 500 as of 4/15/2016. Please note that the historical measures — (Average Annual) Return, Cor(relation), Vol(atililty) and Beta — cover the three year period from 3/31/2013 through 3/31/2016.

Interestingly, we see why bonds in general are good diversifiers for stock-heavy portfolios. The AGG bond ETF is the least correlated with SPY and least volatile in the group, but also generates the least amount of return.

A more nuanced review of the investment characteristics of our four low volatility ETFs reveals that SPHD’s dividend tilt better compliments the S&P 500’s large cap blend approach with the best (lowest) non-bond correlation at 73% and low market beta (less market risk) at 64%. USMV is more correlated with the S&P 500 at 88% given its relatively broader stock selection criteria, but also provides better risk adjusted returns (11.80% / 9.26%). ACWV’s partial foreign stock allocation hurt its returns for test period, but will probably do better going forward whenever Europe and Asia recover.

Please remember that all these measures will change depending on the time period covered.
Measuring the Low Volatility Diversification Effect 
Now, let’s build a series of 80-20 core-satellite mini portfolios using the S&P 500 Index ETF (SPY) as our low-cost, passive core holding, and then substitute in our four low volatility ETFs for our satellite positions. To make the comparison more informative, I also ran this analysis with 100% S&P 500 Index ETF (SPY) only and with the bond index ETF (AGG) as a 20% satellite holding to simulate the more traditional stock-bond portfolio. The table below contains the results for the three year test period, 3/31/2013 through 3/31/2016.

SPY Only
Disclosure: Return is the average annual return of the mini portfolio from 3/31/2013 to 3/31/2016; Vol. is the 3 year historical standard deviation as of 3/31/2016; CAGR is the Compound Annual Growth Rate of the mini portfolio from 3/31/2013 to 3/31/2016; Ret/Vol is the ratio of return earned per unit of risk taken; E.R. is the mini portfolio's expense ratio or internal management fee; Beta is the mini portfolio's 3 year historical beta from 3/31/2016 to 3/31/2016; D.M. is the mini portfolio's Diversification Metric (DM), or non-market beta. All return values include internal fund fees, but are gross of advisor fees, taxes and trading costs. Source: Koch Capital, Quantext Portfolio Planner

All four of the mini portfolios with low volatility ETFs delivered better risk-adjusted returns (Ret/Vol) than the SPY-only portfolio with CAGRs (two above, two below) comparable to the SPY-only CAGR. Moreover, all four low volatility mini portfolios exhibited better diversification as measured by their lower betas (less than SPY’s 100%) and their higher diversification metric (DM) scores (greater than SPY’s zero). 

At Koch Capital we try not to use financial jargon to explain complex investment concepts. For example, the investor can think of “beta” as a measure of return consistency. The lower (from 100%) the mini portfolio’s beta, the less dependence on stock market returns, thus the better the mini portfolio’s return consistency.

Likewise, the higher (off zero) the DM score, the more sustainable the mini portfolio’s returns in any given year. This is why the one mini portfolio with the bond holding (AGG) is technically the best diversified in terms of return consistency (beta=81%) and sustainability (DM =29), but you’ll probably give up some upside growth potential given the lower but steady return contribution from bonds. For a detailed discussion on portfolio diversification, please read Making Sense of a Portfolio Evaluation blog post.

When To Use Low Volatility Diversification 
At Koch Capital we use these four low volatility ETFs frequently in our retirement portfolios to reduce volatility drag and boost risk-adjusted returns. However, these products make sense for young investors too, especially for those in stock-heavy portfolios with many years before retirement, and are uncomfortable with the volatility of an all stock portfolio based on traditional market capitalization weighting. Please see Should You Be 100% Invested in Stocks blog post for my stock allocation criteria.

In summary, if you have an all stock portfolio that is growth oriented, loaded up with technology and consumer discretionary stocks for example, then consider a small allocation to either SPLV or SPHD. If your existing portfolio’s dividend yield is already low, then favor SPHD. If your stock-heavy portfolio is already tilted toward value, then consider USMV or ACWV. And if your value portfolio consists of just US stocks, then favor ACWV to gain a little foreign stock exposure.

Thank you for your interest........Jim

About Jim Koch 
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to advisors, individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement income planning solutions for clients.

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