The Goals of ACWV
Theoretically, low volatility could be neutral. One can imagine that less rambunctious stocks might tend to rise or fall at the same diminished rate, gaining 5% when the broad market gains 10% and similarly losing 5% when the average loss is 10%. In reality, historical results show a favorable bias. When most stocks rise 10%, less volatile ones may gain, say, 7%; but when a 10% loss hits the broad market, less volatile stock may lose only 5%. Over a long period of time, then, less volatile stocks have tended to out-perform. They lag a bit in up-markets, but suffer far less in down-markets.
In MSCI's research, covering the period from 1988 to 2016, their global low-volatility index had a double advantage over an index of all stocks wordwide. It had better annual returns for the 28-year period, 8.75% vs. 7.26%, while also having a lower standard deviation (a measure of annual volatility), 11% vs 15%. Better returns and less risk? It seems too good to be true. Or to last forever. One can't help wondering if, as the investment world wises up, the benefits of low-volatility stocks may diminish.
Indeed, academic researchers have yet to agree on an explanation for the low-volatility effect, nor on a standard way to measure it. MSCI's method is one of several, in an area that remains new enough to capture a minor fraction of investors' dollars. It's the method I've chosen for this post because of the unique position of ACWV as having a five-year history, low costs, and global reach. (In subsequent posts, I'll review other good options.)
Five-Year Performance of ACWV
Visually, these results can be seen in two charts. The first compares weekly data from October 18, 2011, to November 28, 2016, for ACWV and a balanced portfolio. The balance was 80% invested in VT and 20% in long-term Treasury bonds (Vanguard VGLT). The rationale for the 80-20 portfolio is that mixing stocks with bonds is a traditional way to reduce volatility. Furthermore, long-term Treasuries tend to be negatively correlated with stocks; when one zigs, the other zags. One might expect the mixture to resemble low-volatility stocks, generating good returns at reduced risk. An 80-20 ratio was chosen to match ACWV on volatility; it was rebalanced when the stock portion drifted above 83% or below 77%, as recommended in our article on rebalancing.
The chart measures volatility in a way that may be more intuitive than, say, the standard deviation. Each marker in the chart represents an occasion when, over a four-week period, a portfolio lost value. In effect, it shows the frequency with which you might have felt some anxiety, if you inspected your portfolio monthly. The portfolio invested 100% in ACWV had 18 such occasions, or about one every four months. The mixed 80-20 portfolio had 19 of them. Both had mostly small losses of 2% or less, and both kept the maximum monthly loss under 6%.
A key takeaway from this analysis is that investing in low-volatility stocks reduces churn by about the same amount as crafting an 80-20 mix of stocks and bonds. However, during periods when stocks are rising or flat, as occurred respectively from 2012 through 2014, and from 2015 to 2016, low-volatility stocks may generate equal or better returns than a classical mix of stocks and bonds.
Importantly, this five-year analysis failed to include a time when stocks fell extremely. If stocks were to drop as sharply as they did in 2008-2009, perhaps a mixed portfolio would fare better than low-volatility stocks, because of the negative correlation with which Treasuries tend to rise as stocks panic. Still, all indications are that both a fund like ACWV and a mixed portfolio would fall in value less sharply than the broad stock market.
- What about currency risk? In ACWV, roughly half the stocks are purchased in currencies other than the U.S. dollar. Some alternatives, notably a fund from Vanguard, hedge against changes in currency exchange rates, thus potentially reducing another source of volatility.
- What if you prefer less international exposure? In that case, better options may be to craft a simple portfolio of a few funds, some of which specialize in low-volatility stocks in the U.S. or in a particular international sector.
- Finally, what about other factors? Low-volatility is but one of several methods that research has shown to be effective for building a robust portfolio of investments. Is it prudent to combine low-volatility funds with other factors, such as value, size or momentum?