Low Volatility - Low Beta ETFs | Summary and Q&A

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June 8, 2019
by
Ben Felix
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Low Volatility - Low Beta ETFs

TL;DR

Low volatility stocks, which have historically outperformed the market, can be explained by exposure to known risk factors, eliminating the notion of a free lunch in investing.

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Key Insights

  • ✳️ Market beta is a measure of an asset or portfolio's sensitivity to market risk. Historically, low beta stocks have outperformed high beta stocks in terms of risk-adjusted returns.
  • 😘 The efficient market hypothesis posits that asset prices accurately reflect current information, including risk. However, the low volatility anomaly challenges this hypothesis.
  • 🧑‍🏭 The introduction of the three-factor model and later the five-factor model explained the excess returns of low volatility stocks by incorporating additional risk factors.

Transcript

  • You may remember that market beta is a measure of the sensitivity between an asset or portfolio and the risk of the overall market. A portfolio with a beta of one moves with the market, so if the market drops 10%, we would expect the portfolio to do the same. A portfolio or asset with a lower beta would be less volatile than the market. In an eff... Read More

Questions & Answers

Q: Why have low volatility stocks historically provided market-like returns with less volatility?

Low volatility stocks had exposure to risk factors like value, profitability, and investment, which were not accounted for in previous asset pricing models. These factors explain the higher returns of low volatility stocks.

Q: Does the low volatility anomaly still exist?

The low volatility anomaly has been debunked with the introduction of the five-factor model, which explains nearly 100% of the differences in returns between diversified portfolios. The excess returns of low volatility stocks can be attributed to known risk factors.

Q: Are low volatility ETFs a good investment?

While low volatility ETFs may offer exposure to factors that explain differences in returns, there are some problems to consider. These ETFs generally have a concentrated portfolio, higher turnover, and higher fees compared to regular index funds. A more efficient approach would be to maintain exposure to the whole market and directly exclude small cap growth stocks with weak profitability.

Q: Has this analysis changed the perception of low volatility ETFs?

The analysis provides a better understanding of the factors driving the performance of low volatility stocks. It suggests that investing in traditional index funds may be a more suitable approach for most investors.

Summary & Key Takeaways

  • Low volatility stocks have consistently delivered market-like returns with less volatility, challenging the efficient market hypothesis.

  • The capital asset pricing model and the three-factor model failed to explain the higher risk-adjusted returns of low volatility stocks, leading to the belief in a low volatility anomaly.

  • However, the introduction of the five-factor model, including factors like profitability and investment, has explained the excess returns of low volatility stocks, aligning with the efficient market hypothesis.

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