The purpose of minimum-volatility funds in client portfolios
John Ameriks is an active portfolio manager, but he thinks one successful strategy should not be used in an attempt to outperform the stock market. Ameriks, a principal and head of Vanguard Quantitative Equity Group, said research published as far back as the early 1970s has demonstrated that low-volatility stocks tend to outperform the highest-risk stocks over time. Nonetheless, Ameriks, whose team manages Vanguard Global Minimum Volatility Fund, says there are other, more important reasons advisors should consider using funds or ETFs focused on that strategy in client portfolios.
“There is another purpose of active management besides outperformance, and that is the purpose of managing risk,” Ameriks said. “That’s what we think minimum volatility is really all about— providing a quantitative method for lowering volatility while remaining fully invested.”
Ameriks shared his thoughts at September’s 2016 Morningstar ETF Conference, where he participated in a panel titled “Low-volatility strategies: Less risk, more reward?” Ameriks believes that, if done well, such strategies can regularly result in higher risk-adjusted returns. That means higher returns for the risk taken, and not higher returns overall.
“Low volatility is not a new anomaly,” Ameriks said. “It’s a long-term pattern, and it cuts across markets. There is plenty of evidence that you can systemically reduce volatility by being judicious about securities you hold and the process you use to select them. We expect a reduction in return in holding low-vol stocks when compared with the overall market, but hopefully, it’s not as large as the reduction in risk.”
How can this be? Aren’t markets efficient?
There are some behavioral explanations for why low-vol or min-vol strategies can succeed even though, in principle, higher risk typically leads to greater reward, Ameriks said.
Individual investors tend to be attracted to companies that are growing quickly, whose stocks may offer quick gains. “They’re there to ’take a flyer‘ on a company like Alibaba, because maybe it goes to the moon. They figure it’s at least as good a deal as a lottery ticket. But they may end up—on average—overpaying for exposure to that higher volatility.”
Meanwhile, as a result of policy or leverage constraints, institutional money managers may also tend to invest in segments of the market deemed riskier—such as small-cap or emerging markets stocks—when seeking higher return and, thus, potentially overpay as well.
Therefore, it can be the more predictable companies and stocks that offer a greater return for the risk they offer, Ameriks added, creating a quandary for proponents of the Capital Assets Pricing Model, who believe in the efficiency of markets.
“These behavioral stories make some sense,” Ameriks said. “Vanguard doesn’t believe in perfectly efficient markets. We do believe it’s very hard to beat markets, but with discipline, low costs, diligence, and skill, it is possible to pick up premium. We don’t think it will be a large premium, but as active managers, we believe it is there.”
Favored now, but what about later?
Low-vol strategies have performed well in recent years, leading to an influx of cash flow, Ameriks said.
Low-vol ETFs and index-based products are not typically based on market capitalization, as is the case with most index products. Instead, many low-vol ETFs are based on an index that ranks stocks by standard deviation of their stock prices, a generally accepted measure of volatility.
Ameriks said Vanguard Global Minimum Volatility Fund, which is offered only as a mutual fund and not as an ETF, works differently. Besides standard deviation, the fund uses a quantitative process to select stocks that are less correlated with one another and can balance one another in such a way as to reduce volatility in the portfolio. Then the fund limits the holdings so they are not concentrated in any particular industry, style, or country.
The quantitative model can potentially deliver 20% to 30% less volatility than the overall market over a 90-day period. The fund also can have a much higher turnover rate—ranging from 50% to 80% in a given year—compared with index funds. The fund holds approximately half its assets in U.S. stocks and half in global stocks, hedging currency as an attempt to further mitigate volatility.
Ameriks said he expects the fund to perform well when the market is volatile. Still, like any active strategy, there will be periods of underperformance, and those may present the greatest challenge to investors.
“Like other active strategies, everybody loves low-vol and min-vol strategies when they are doing well. When the markets are down, we expect the Global Minimum Volatility Fund to be less down, hence outperform. But when we get a breakout run in the markets, which will likely happen again at some point, we expect this fund, and other min-vol or low-vol strategies, to be behind substantially,” he said.
That will be a key moment.
“Can investors remember why they invested in this to begin with? They should be there for defensive reasons, to lower their volatility,” he added. “The fact that they’re trailing the market and giving up return hopefully doesn’t change their point of view. It if does . . . then they never should have been invested there in the first place.”
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