REVIEW: The High Price of ‘Low Volatility’ Funds

Low-volatility stocks are hot right now. It makes sense—stocks with low levels of volatility seem to have higher rates of return, and, well, lower levels of volatility. It sounds great. In fact, the question shouldn’t be “Why are they so popular?” but “Why weren’t they this popular before?”

When you break them down though, you need to pay attention to a couple things. First, this seems to be largely a repackaging of the good old value premium. These low-volatility stocks tend to be mature businesses with well-understood business plans that pay regular dividends. That sounds suspiciously like the prototypical value stock. Now, I don’t mean to say that “low volatility” is just another name for “value”—it’s not. But they seem to be closely related.

The other thing to consider is that volatility is not the same as risk. We often use “volatility” and “standard deviation” as proxies for “risk,” but that’s because those measures are quantitative and relatively easy to work with. Both terms generally work nicely for how most people talk about risk most of the time, but risk and volatility are different.

Think about it this way, were AAA-rated mortgage-backed securities safe investments in 2007? Everything looked great about them—the rating agencies said they were incredibly safe, they had high rates of return—and then everything blew up.

It’s highly unlikely that low-volatility stocks will blow up in quite so spectacular a fashion (at least, I hope they don’t), but that’s kind of the point. No one thought those mortgage-backed securities were going to blow up, either. Just because I don’t know what the risks are doesn’t mean they’re not there.

So what does this mean for you? As always, you need to focus on risks that make sense. You also need to be thinking about how to structure your total portfolio to capture appropriate types and levels of risk. For more on how to do this, take a look at our ebook, “12 Principles of Intelligent Investors.”

 

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