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A Framework for Evaluating Low-Volatility Funds

It’s important to have a strong framework to evaluate how these funds are built.

Alex Bryan 31/05/18

Well-constructed low-volatility stock funds should offer better downside protection, a smoother ride, and better risk-adjusted performance than the market over the long term. But not all low-volatility funds are created equal. Differences in how they are constructed can affect performance and their odds of success. It’s important to have a strong framework to evaluate how these funds are built.

Portfolio Construction Framework

1. What’s the selection universe?

The selection universe is the fund’s starting point, or parent index. It should serve as the benchmark against which you gauge the fund’s risk and risk-adjusted performance. It can also offer insight into the riskiness of the fund itself. For example, large-cap stocks tend to be less volatile than small-cap stocks, so the most risk-averse investors should probably stick to low-volatility strategies that draw exclusively from the largest stocks. That said, the performance improvement from tilting toward low-volatility stocks tends to be the greatest in the small-cap arena.

2. Does the fund consider each stock’s volatility in isolation, or does it account for how stocks interact with each other in the portfolio?

The former approach yields greater exposure to the least-volatile names in the selection universe, more closely capturing the low-volatility effect docu¬mented in the academic literature than the latter, more holistic approach. That said, it can also lead to a less diversified portfolio that loads up on a few sectors or stocks that may have common exposure to other risk factors, like interest rates. This can introduce risks that past volatility alone does not capture.

The holistic approach to stock selection is probably more suitable for a fund that serves as a core holding. No measure of past risk is perfect. Incorporating correlations across stocks in the portfolio construction process improves diversification, which helps mitigate the damage if the riskiness of the fund’s holdings picks up. So, even though these portfolios may have less exposure to the least-volatile stocks than funds that key on individual stocks’ volatility, they may actually have less volatility at the portfolio level. The knock against funds that use this approach is that they’re more complex and typically rely on an opaque optimization process to build their portfolios.

3. How does the fund measure volatility?

The most common statistical measures of risk that low-volatility funds use to select stocks are standard deviation of returns and market beta. Some also include fundamental measures of risk, such as vola¬tility of earnings or leverage. However, one approach isn’t necessarily better than the others; while incorporating fundamental measures of risk can paint a more complete view of risk, they can also dilute the portfolio’s exposure to the least-volatile stocks in the market.

It is more important to focus on the period over which low-volatility funds measure risk and whether they measure each stock’s risk relative to its sector or the entire universe. Stocks’ volatility relative to each other tends to persist, but that persistence has historically been strongest in the short term. Funds that use a shorter lookback period (like a year) to measure volatility and rebalance frequently should be able to get out of the way faster if volatility in a particular area of the market picks up. So, they should be able to better reduce volatility than funds that use a longer lookback period. The downside is that they tend to have higher turnover, though the benefits should outweigh the costs.

Measuring each stock’s volatility against its sector peers can help reduce sector tilts relative to the market, which can be a source of uncompensated active risk that isn’t necessary to capture the low-vola¬tility effect. However, this approach also tends to give a fund greater exposure to more-volatile sectors, like materials and technology, than targeting stocks with low volatility relative to the entire selection universe. Despite this trade-off, it is prudent to have some constraints on sector bets either through explicit sector limits or sector-relative stock selection. Large sector tilts are a source of active risk that are not necessary to realize the benefits of a low-volatility strategy.1

4. Are there any portfolio constraints?

While constraints like limits on sector, country, and stock weightings and nontargeted factor exposures can reduce a fund’s style purity, they often help more than they hurt. Such constraints can improve diversification, mitigating potential losses if particular sectors or holdings fall out of favor. Turnover constraints are less important, but they can help modestly reduce transaction costs.

5. How frequently does the portfolio rebalance?

More-frequent rebalancing (quarterly or monthly), coupled with a short volatility measurement period, should help a low-volatility strategy get out of the way faster as the volatility of its holdings increases. This should translate into a greater volatility reduction. Rebalancing frequency doesn’t move the needle as much with a long lookback period.

1Bryan, A., & McCullough, A. 2017. “The Impact of Industry Tilts on Factor Performance.” Morningstar.

About Author Alex Bryan

Alex Bryan  

Alex Bryan is the Director of passive fund research with Morningstar.