Equity investors have a choice between active low volatility managers and low volatility index ETFs. Index strategies offer a transparent and often cheaper alternative to active low volatility investing, but in our view this comes with several drawbacks.
In this article, we will compare the methodology of the two most popular low volatility indices with our active Robeco Conservative Equities strategy, and address five concerns we have with low volatility index ETFs. The indices are the MSCI Minimum Volatility Index, available through iShares, and the S&P Low Volatility Index, available through PowerShares. They form the basis of the ten largest low volatility ETFs.
Although we see the merits of index investing, as they offer transparent exposure to the low risk factor, we have some concerns with smart beta indices. The original idea of passive index investing is to provide low-turnover, low-cost exposure to equity markets. These principles are watered down in smart beta indices, which are by definition active strategies and can have a high turnover. Moreover, we have several concerns with low volatility indices. We will address five of them.
Low volatility indices, as every smart beta index, have a low capacity because of possible index arbitrage. As smart beta indices are public, including their methodology and rebalancing dates, they are prone to index arbitrage by market participants such as hedge funds. A recent Robeco study indeed confirms that there is an effect of index rebalance announcements and subsequent stock price movements. Stocks that are announced to be added to the index rise in price before actually being included in the MSCI Minimum Volatility Index, while the opposite effect is observed for deletions. Both effects are disadvantageous for index investors as an ETF on the index buys the additions at a higher price and sells deletions at an already lower price. These effects become larger as assets in smart beta ETFs grow.
Both the MSCI Minimum Volatility and S&P Low Volatility Index can have significant negative exposure to other proven factors like value and momentum. Our research shows that this can hurt the performance of any low risk strategy substantially. For example, although the MSCI Minimum Volatility Index takes into account several risk factors, the index can have a relatively high valuation, as has been the case in recent years. Since inception of the Robeco Conservative Equities strategy, its P/E has been lower than that of the minimum volatility index.
We prefer to have a broad investment universe, which enables us to be selective. We do not just look for low risk stocks; we want to hold low risk stocks that offer good value and momentum exposure, with a high and stable dividend yield. A larger universe allows us to invest in the most attractive low risk stocks for our clients.
Most low volatility indices have limited breadth, as only stocks from the parent index are considered. This is especially the case for regional indices. For example, while the popular PowerShares S&P 500 Low Volatility ETF (SPLV) only chooses from 500 stocks, our US Conservative Equities strategy selects from 2,400 investable stocks in the US and Canada, which gives us much more breadth. Our research shows that larger breadth enhances the risk/return profile of factor strategies.
We consider the MSCI Minimum Volatility Index as too complex and the S&P Low Volatility Index as too simple. The methodology of the MSCI Minimum Volatility Index is quite complicated, as it uses a quadratic optimization process, subject to several constraints. The index relies heavily on correlation estimates and can contain low correlation stocks that have a high stand-alone volatility. We prefer low volatility stocks to low correlation stocks.
Conversely, the S&P Low Volatility Index has an overly simple methodology. The index relies on just one risk factor, volatility, and just one lookback period of one year. Other factors like value and momentum as well as concentration risks are ignored.
We think the virtue is in the middle. In our Conservative Equities strategy, we make limited use of correlations, as the beta factor is one of our three low risk factors, next to volatility and credit risk, but do not let correlations take over control in portfolio construction. Our stock weighing scheme mainly leans on equal-weighting, while having liquidity and concentration limits in place.
The MSCI Minimum Volatility Index rebalances semi-annually, while the S&P Low Volatility index has a quarterly cycle. We see three drawbacks:
We have five concerns with popular low volatility indices and their ETFs. With our active, enhanced approach to low volatility investing, we aim to avoid these pitfalls.
The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.
The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.
Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is ACOLIN Fund Services AG, Affolternstrasse 56, 8050 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult www.finma.ch for a list of FINMA registered funds.
Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/RobecoSAM AG product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/RobecoSAM AG offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.
This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.