Monday, December 9, 2013

Sander, All About Low Volatility Investing

A 2011 study in the Financial Analysts Journal highlighted, and sought to explain, the seemingly anomalous long-term success of low-volatility and low-beta stock portfolios. The success of these portfolios is anomalous because their high average returns and small drawdowns “run counter to the fundamental principle that risk is compensated with higher expected return.” Over the 41 years between January 1968 and December 2008 a dollar invested in the lowest-volatility portfolio, assuming no transaction costs, increased to $59.55 whereas a dollar invested in the highest-volatility portfolio was worth a mere 58 cents by the end. In real terms, the former produced a gain of $10.12, the latter a loss of more than 90 cents (or 90%). The authors of the study argued that low volatility portfolios outperformed because “exploiting [the anomaly] involves holding stocks with more or less similar long-term returns (which does not help a typical investment manager’s excess returns) but with different risks, which only increases tracking error. So, even though irrational investors happily overpay for high risk and shun low risk, investment managers are generally not incentivized to exploit such mispricing.” And, they concluded, “so long as most of the investing world sticks with standard benchmarks,” the advantage will go to low volatility investors.

Critics will be quick to point out that volatility and risk are not the same. That’s true, of course, but let’s not get tripped up over theoretical distinctions, however important. The fact remains that, for whatever reason—and some would point to the tough uphill climb after large drawdowns, low-volatility low-beta investing has outperformed handily.

Peter Sander’s new book (he has written 39!), All About Low Volatility Investing: The Easy Way to Get Started (McGraw-Hill, 2014), introduces investors to this strategy. He wants it to be accessible to math-phobes and stresses that “informed common sense will help you more than [quantitative models] in making the right decisions.” (p. 84) But the reality is that you can’t write about volatility without describing it statistically. So Sander succumbs even as he maintains that investors need to know concepts and relationships, not formulas. It’s about the thought process, he claims, not the actual measurement.

The second part of the book moves beyond the somewhat tortured “what” of volatility to the “how” of becoming a low volatility investor.

Sander begins at the level of portfolio construction. He suggests building a three-tiered portfolio comprised of foundational, rotational, and opportunistic investments. Low-volatility investments belong to the foundational portion of the portfolio, along with such long-term investments as real estate, trusts, and collectibles. Rotational investments are those that take advantage of business cycles such as sector-specific ETFs. Opportunistic investments/trades include high beta stocks and options. The weightings of these categories of investments will depend on how conservative or aggressive the investor is. A sample tiered portfolio would consist of classic low volatility stocks (30%), low volatility funds (30%), real estate income (10%), inflation hedge (10%), sector funds (5%), inverse/low correlated (5%), strategy funds (5%), and “hot stuff” (5%).

The investor, of course, still has to figure out what stocks and funds to buy to fill out his tiered portfolio. Sander gives some pointers on what to screen for; he suggests that among the core indicators of low volatility are dividends, beta, size, and growth. When all else fails, look at a chart, especially one with Bollinger bands.

Sander’s book is elementary, but for investors intrigued with low volatility investing it’s a decent starting point.

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