Do Low-Volatility Products Belong in Your Portfolio?

"The prudent see danger and take refuge, but the simple keep going and pay the penalty." - Proverbs 27:12

It's hard to remember an asset class or investment strategy that, while still being unfamiliar to most investors, has attracted more attention or been the subject of more debate in the financial media over the past year than "low volatility."

Low-volatility products, mostly in the form of exchange-traded funds, are designed to track indices that are weighted toward stocks that have recently demonstrated less price fluctuation than the overall market. According to AltaVista Research, the category's combined assets under management have grown from around $1 billion at the end of 2011 to more than $40 billion today, with about a third of that total being invested this year alone.

It's this recent popularity and the corresponding outperformance relative to the broader market that has led to concerns about potential overvaluation and some predictions of a "reversion to the mean." An offsetting future underperformance would expose investors attracted to these vehicles to more risk than they were expecting.

Conversely, there are those who believe such investments are still appropriate core holdings for many portfolios, and that they are not over-popular, given that only a relatively small fraction of the trillions invested in equity markets is tied to these strategies.

Here, then, are some considerations and caveats, if you are contemplating whether low-volatility products belong in your own portfolio:

1. Check out FINRA's Investor Alert on Smart Beta investing, which contains a description of one of the most popular low volatility strategies. Smart Beta refers to indices weighted not on the basis of the market capitalization of their constituents (as is Standard & Poor's 500-stock index, for example), but on the basis of certain factors, or characteristics, of which low volatility is one.

2. Evaluate valuation and look under the hood. It's notable that half of the top ten holdings of each of the two largest low-volatility ETFs had suffered year-over-year revenue declines in the most recent quarter. The same can currently be said for only two of the top ten components of the S&P 500. Couple that with the fact that these indices have average price-earnings ratios that are more than 15% higher than the S&P, and it's easy to see the potential validity of overvaluation concerns.

In any case, when these strategies ultimately do underperform the broader market, as all strategies do at some point, it could be a most unpleasant harbinger: The last two periods of meaningful, back-tested underperformance versus the broader market were 1998-1999 and 2007, which preceded the two largest market declines since the Great Depression. In addition, the low-volatility indices, at least in the realm of large-cap U.S. stocks, had only a modestly lower drawdown than the broader market during the financial crisis.

If pursuing lower volatility appeals to you, but you'd like to couple that with potentially more favorable valuations or other characteristics not adequately represented in low-volatility products, consider ones that pair low volatility with other factors such as value, quality (stronger balance sheet with historically more stable revenues and earnings), cash flow, momentum (relative price performance) and others. These so-called "multi-factor" products, or even some active managers who have demonstrated the ability to follow the desired approach in a cost-effective manner, may be more appropriate for your portfolio. Obviously, there's no guarantee that any particular factor—or combination of factors—will produce favorable results or outperform a passive, cap-weighted index.

3. Don't forget about bonds (plain bonds—shaken, not stirred). If it's consistent with your objectives, consider incorporating some high quality, low- and intermediate-duration fixed-income holdings into your portfolio, if you haven't done so already. Even in a world of historically low interest rates, and therefore theoretically elevated interest-rate risk, a balanced portfolio can potentially reduce volatility, as well as downside during steep market declines, in place of, or as a supplement to, a low-volatility equity strategy.

4. Act incrementally, if at all. Many financial writers and industry observers have a penchant for "all or nothing" proclamations, but no one can predict future performance with the degree of certainty such confidence implies.

If you do decide to invest in this area, and you determine that doing so is consistent with your objectives, consider starting with a partial position and adding to it opportunistically, if appropriate, over time, being mindful of trading costs. Likewise, if you are already in this group and are considering getting out due to valuation or other concerns, consider trimming positions incrementally, as well, while also including any potential tax consequences in your decision. Since products that track low volatility indices will, by definition, rebalance their holdings periodically to reflect recalculation of those indices, it's possible for portfolio composition to change substantially, including with regard to sector representation and valuation characteristics. And underlying fundamentals and investor sentiment can change even when the portfolio doesn't.

5. Beware of back-testing. By now, most investors have likely seen or heard some variation of the phrase "past performance is not indicative of (or is no guarantee of) future results" numerous times. As problematic as it can be to use past performance to try to predict the future, back-testing—the process of attempting to mathematically validate an investment strategy in time periods before it was actually deployed with investors' money—should be viewed even more cautiously. For various reasons, including the fact that the mere existence of an investment vehicle not previously available in a market sector can affect that sector's performance once it is introduced (many point to gold, energy and high-yield bond products as examples in that regard), back-tested results should be taken with a grain of salt, to say the least. In the words of FINRA on this topic, "while back-tested results and some academic research have highlighted the potential efficacy and attractiveness of alternatively weighted indices, it remains an open question how the indices and products tracking them will behave in different market environments going forward."

Andre Korogodon is a Registered Principal at Cantella & Co., Inc., member of FINRA/SIPC, with the Series 86/87 registered Research Analyst designation.