ETF Beating Market With Gains Less Price Swings: Riskless ReturnCharles Stein
Investors who bought PowerShares S&P 500 Low Volatility Portfolio for protection from stock-market swings when it debuted almost two years ago got an unexpected bonus: They also made more money.
The $4.1 billion exchange-traded fund, which owns the 100 stocks in the Standard & Poor’s 500 Index with the lowest volatility, gained 30 percent since its inception on May 5, 2011, compared with 21 percent for the benchmark U.S. index. The ETF, the largest of its kind, achieved that performance with about 70 percent of the volatility in the index, giving it a risk-adjusted return double that of the market, according to the BLOOMBERG RISKLESS RETURN RANKING.
The PowerShares ETF, offered by a unit of Atlanta-based Invesco Ltd., is the oldest and the biggest in a group of funds opened since the financial crisis to attract investors seeking equity returns without the unprecedented price swings that followed the 2008 failure of Lehman Brothers Holdings Inc. BlackRock Inc., the world’s biggest money manager, Putnam Investments and Janus Capital Group Inc. have since started similar funds designed to lower the impact of price swings.
“Our clients have to sleep at night,” John O’Connor, president of 3D Asset Management in East Hartford, Connecticut, whose $650 million in assets under management include an investment in the low-volatility ETF, said in a telephone interview.
The PowerShares ETF is based on an index that is compiled and maintained by Standard & Poor’s S&P Dow Jones Indices, which takes the 100 least-volatile stocks over the past year in its S&P 500 Index and assigns the greatest weight to those shares with the smallest price swings. The result is a collection that looks very different from the traditional benchmark.
In the low-volatility index, utilities represented 31 percent of the portfolio, compared with 3.4 percent in the regular U.S. benchmark, and consumer staples accounted for 24 percent, versus the index’s 11 percent at the end of February, according data from Standard & Poor’s. Information technology, which represents 18 percent of the S&P 500, made up 3.6 percent of the low-volatility portfolio.
Among the biggest individual holdings in the PowerShares ETF are Johnson & Johnson and PepsiCo Inc., the two stocks in the S&P 500 with the lowest volatility over the past year --10.1 and 10.4, respectively. Johnson & Johnson, based in New Brunswick, New Jersey, advanced 21 percent in the 12 months ended March 15, and Purchase, New York-based PepsiCo climbed 18 percent.
The biggest contributor to the ETF’s performance over the past year include H.J. Heinz Co., the Pittsburgh-based ketchup maker being acquired by Warren Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc., portfolio data compiled by Bloomberg show. Hershey Co., the Hershey, Pennsylvania-based candy company, was the second-biggest.
The PowerShares ETF gained 2.2 percent, adjusted for price swings, since it was created on May 5, 2011, compared with a 1.1 percent return for the S&P 500, according to data compiled by Bloomberg.
The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.
Some academic research has found that over time, buying less volatile stocks produces both results that are comparable, and often better, than those of broad market indexes, with the added benefit of giving investors a smoother ride.
“The long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance,” Harvard Business School Professor Malcolm Baker wrote in a 2011 paper in Financial Analysts Journal.
When S&P designed the low-volatility product, it traced the history of the index back to 1990 in a process known as backtesting. The numbers showed that over three, five years and 10 years, the low-volatility index had a higher total return than the S&P 500.
Harvard’s Baker said market data going back to the 1930s show that low-volatility stocks have delivered about the same returns as market indexes, a result that contradicts the notion that higher risks translate to higher rewards.
“In this case you are taking less risk, but not giving up any return,” he said in a telephone interview.
Other studies have come to similar conclusions, according to Joel Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc., who said finance scholars have a hard time explaining the mismatch. Most theories attempting to explain it revolve around investor behavior. Because people are overly smitten with fast-growing, glamorous companies, they bid up the prices of those stocks to the point where future returns suffer, said Dickson.
Dickson offers a caveat. When stocks soar as they did in the 1990s, low-volatility holdings can underperform for long stretches, said Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc.
“As an investor you have to be willing to stomach periods when this strategy gets killed,” Dickson said in a telephone interview.
In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index.
O’Connor of 3D Management is aware there will be times when the low volatility ETF trails the market. Still, he said, it is rational to hold it in one’s portfolio.
“People love volatility when stocks are heading up,” he said. “They hate it when stocks are going down.”
Stock-market swings eased to a six-year low last week as signs of a brightening economy pushed the Dow Jones Industrial Average to a record. The Chicago Board Options Exchange Volatility Index, or VIX, has plunged 20 percent this year.
Traders are placing a record number of bets that U.S. stock-market swings will rise on speculation that volatility has fallen too fast. The shares outstanding for the iPath S&P 500 VIX Short-Term Futures ETN, the most-active security that tracks changes in VIX futures, climbed to an all-time high of 64 million this year as of March 15, data compiled by Bloomberg show.
Offering a smoother path for investors has become a popular sales pitch asset-management firms in the aftermath of the financial crisis.
“Risk-adjusted returns, rather than swing-for-the-fences returns, are absolutely more important,” Richard M. Weil, chief executive officer of Janus Capital Group Inc., said in a February interview with Bloomberg News.
Janus, following the lead of BlackRock, Invesco and Goldman Sachs Group Inc., has introduced funds that seek to spread risk across asset classes and protect clients from sharp market drops. BlackRock introduced low-volatility ETFs in October 2011, including the $2 billion iShares MSCI USA Minimum Volatility Index Fund. Invesco PowerShares, which managed more than $70 billion as of Dec. 31, has five ETFs designed to minimize volatility.
Low-volatility ETFs that BlackRock and Invesco have opened to invest in developing-market stocks have beaten the benchmark MSCI Emerging Market Index on risk-adjusted basis since inception, according to data compiled by Bloomberg. Some of the other low-volatility products are too new to have meaningful results.
Joshua Emanuel, chief investment officer with Elements Financial Group LLC, in Irvine, California, said the PowerShares product is a good fit in the current environment. With stocks sporting “healthy” valuations, he said he doesn’t want to own equities that will depend on strong global growth to carry them higher.
“I want a stable portfolio that has some income associated with it,” said Emanuel, who oversees about $400 million.
The PowerShares ETF has a dividend yield of 2.78 percent compared to 2.13 for the S&P 500 Index, according to data compiled by Bloomberg.
The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500.
“Protecting yourself on the downside may lend itself to outperformance over time,” Taylor Ames, senior equity strategist for Invesco PowerShares, said in a telephone interview.