Parsing Low Vol And Low Beta
May 30, 2012
Think low volatility and low beta are the same? Think again.
Russell offers two ETFs that track modified versions of the Russell 1000, one with a low-beta strategy (NYSEArca: LBTA), one with a low-volatility strategy (NYSEArca: LVOL).
Over a three-month time horizon, each of these funds delivered sufficiently divergent returns to make me want to understand what the difference means to investors.
Here’s what I found:
Over the three-month time horizon starting Feb. 17, nearly 5 percentage points of returns separated LBTA and LVOL, with LBTA eking out actual gains. As the graph below shows, LBTA finished in the black, gaining a little over 1 percent, while LVOL fell about 3 percent.
A 5-percentage point difference over three months is nothing to scoff at, so it would be best to stop using “low-beta” and “low-volatility” synonymously and find out what separates these two factor-based approaches to investing.
The answer is that beta is a relative measure and volatility is an absolute measure. Let me explain.
Beta measures how much the price of an asset moves relative to the movement of the market. Volatility, on the other hand, is an absolute measure of price fluctuations in the asset and pays no regard to movements in the broader market.
We generally expect the two measures to yield similar values because most assets exhibit some significant level of correlation with measures of the “broader market.”
As an investor, if I were looking at a low-volatility portfolio I would expect to find assets that also have low betas. Conversely, inside a low-beta portfolio, I would expect to find assets that also exhibit low volatility.
As it turns out, not only is neither assumption theoretically sound, but empirical evidence also suggests the contrary.
High volatility assets can indeed find their way into low-beta funds. Similarly, high-beta assets may be included in a low-volatility portfolio.
It’s not easy for a high-volatility asset to slip into a low-beta fund, but it is possible.
Not only is it possible for a high-volatility asset to slip into a low-beta fund, it happens regularly. In fact, 20 of the 69 constituent securities in Russell’s high-volatility fund are also included in the low-beta portfolio, LBTA.
A highly volatile asset could potentially also be a low-beta asset if it has significant price fluctuations independent of the broader market.
It seems that this scenario would most likely occur when the security is generating headlines of its own that may cause the security to move independent of the market.
High-beta assets also find their way into low-volatility funds. A quick examination of the holdings included in Russell’s low-volatility portfolio, LVOL, shows that 11 of the 104 securities are also included in Russell’s high-beta fund (NYSEArca: HBTA).
How could an asset with a high beta also exhibit little volatility? In this scenario, the asset is strongly correlated with the market but the market itself is exhibiting low volatility.
All of this is a bit technical, but what’s important is for investors to understand what two funds like LVOL and LBTA are actually holding.
To put it as simply as possible: Investors in low-beta funds should be looking for a fund that loses a smaller fraction of its value than the market when the market is down, and gains a smaller fraction when the market is up.
Investors in a low-volatility fund should expect that, regardless of market movements, price fluctuations are minimized.
The low-volatility mandate, as opposed to a low-beta purpose, also results in some interesting differences in sector allocation between LVOL and LBTA.
Now, these sector allocations are not set in stone and could shift significantly at Russell’s next rebalance. However, it’s evident that targeting exposure to beta vs. volatility results in a significantly different portfolio, both in terms of constituent names and sector exposures.
But from the above snapshot, it’s clear that while low volatility and low beta are similar in theory, the portfolio differences and the 5 percentage point performance difference in returns of LBTA and LVOL are very real.
Ultimately, the point is to understand what you hold and know where your risks lie.