Long/Short Investments
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Long/Short Investments in L/S Equity: Valuation and Ideas,

Low Volatility Funds – What’s In Them And Are They Worth It?

Low volatility funds typically target large or mega cap equities, which are typically diversified and/or stable cash-flow producing companies. They are often, but not always, dividend paying stocks, which inherently signals stability by showing that a portion of a company’s earnings is essentially guaranteed.

These funds are generally designed for investors who want exposure to equities (the asset class that generates the highest returns, provided a long enough timeframe) while at a lower volatility to the overall market. Sometimes these are dubbed “smart beta” to add marketing appeal.

However, I’m against these types of a funds for a few reasons:

1) They don’t actually improve risk-adjust returns or expect to generate “alpha.” Return is generally proportional to risk. So if one is staying solely in US equities, but choosing securities that are simply lower in volatility, you might expect lower returns over time as these are inherently lower-growing companies.

2) They’re expensive. US equity ETFs generally have expense ratios of 0.04%-0.05% ($4-$5 for every $10,000 invested). Low vol funds nonetheless start at around 0.25%.

3) They aren’t actually low volatility. They tend to be around ~80% of the volatility of the broader equities market, which is still fairly high. Given they lack diversification into other asset classes, the securities contained therein have a high covariance with each other, which does practically nothing to increase reward-to-risk. “Smart beta” is a misnomer.

Given individual equities highly correlate to each other, one isn’t really increase reward-to-risk anywhere near the extent a less correlated accumulation of assets might. A portfolio comprised entirely of equities might improve its reward-to-risk ratio by something similar to the fourth image below (in order, correlation between/among assets at 0%, 25%, 50%, and 75%):

(click to enlarge)

Due to their high costs, funds of this nature are probably not recommended given the cheaper alternatives among equities. However, for those expecting a downturn, a lower volatility fund could make for a better selection, as it would expect to outperform in a bear market.

The most popular “low vol” fund in the space, SPLV contains 100 different equities and are relatively equally weighted. Over half the fund is made up of stocks in the industrial, financial, and utilities sectors.

(click to enlarge)

The top selection takes up no more than 1.35% of the weight and the lowest takes up no less than 0.80%.