[This article first appeared on our sister site, IndexUniverse.eu.]
Low-volatility index approaches are flavour of the year for many investors. But it’s easy to forget how unstable the historical volatility of individual stocks and sectors can be.
There’s been increasing interest in investing in volatility—or rather, seeking to minimise it—by taking a look backwards.
Low-volatility index approaches (and their close relative, minimum variance strategies) seek to cut portfolio risk by selecting those stocks (or combinations of stocks) that have provided steadier returns in the past than the rest of the market.
According to those sold on the idea, such an approach can provide similar returns to a market-capitalisation-weighted index over a market cycle, but with lower variability—an attractive combination for long-term savers.
An easy-to-understand take on the low-volatility approach is provided by the S&P 500 Low-Vol index, which ranks the 500 stocks in the parent index by their 12-month historical volatility, takes the 100 least volatile from the list and then weights them by the inverse of that historical volatility figure: the less volatile the stock, the higher the index weighting it gets.
PowerShares has raised over US$2.5 billion with its ETF version of S&P’s index, while SPDR has just launched the first European ETF based on the same benchmark.
But just because a stock or sector has been relatively stable in the past doesn’t mean it will be in future.
Take a look at the chart below, sent to me by Steven Goldin of Parala, which shows the 12-month historical volatility of the ten S&P 500 sectors, plotted over a period of 21 years. The stocks comprising each sector are equally weighted to dampen the impact of individual stock price movements.
Click at the bottom right of the chart to enlarge it
Some equity market sectors rank consistently as among the least volatile.
According to Parala, which ranked the ten sectors monthly from 1 (least volatile) to 10 (most volatile), consumer staples never made it higher than 3 over the whole period. Utilities were the next least volatile sector, with an average monthly ranking of 3.5.
But take a look at telecoms, which scored lowest for 12-month volatility for most of 1991 and registered as amongst the least volatile sectors for the rest of the decade, only to hit the top of the risk rankings in 2001 and 2002. That, of course, was during the aftermath of the 1999/2000 “TMT” (technology, media, telecoms) bubble; 2002, in fact, registered a record for telecom company bankruptcies, with WorldCom, XO, NTL and Global Crossing all filing for Chapter 11 insolvency protection.
And financials are a more recent case of a sector going from the bottom to the top of the volatility tables at short notice. Financial stocks were the second-least volatile area of the market for most of 2006 and 2007, with fund managers clearly taking on board Bernanke’s recent boast that improved monetary policy had contributed to a “great moderation” in inflation and output. We all know what happened next.
This doesn’t mean that a low-volatility index approach is invalid. After all, some sectors do stay pretty low-risk throughout the cycle. Other ways of constructing indices, such as the traditional capitalisation-weighting approach, may expose you to bubbles as well. And of course individual limits on sector and stock weightings in a low-vol portfolio can help prevent unpleasant surprises.
But markets are anarchic and like to leave us with eggs on our faces. If everyone starts to agree that low-vol makes sense and what a related index should contain, something surprising is almost certain to happen.