COLUMN-Finding a haven from volatility isn't easy
By John Wasik
CHICAGO, August 2 (Reuters) - Most experienced long-term investors know stocks are volatile and can deal with it. But what if you want to stay in stocks and at the same time reduce your downside risk and avoid a cyclonic year like 2008?
You might be tempted by funds that bill themselves in a "low volatility" category, though "volatility" is a red herring. A "low-beta" approach might be better.
Beta is a measure that portfolio managers use to determine a portfolio's sensitivity to a major index. A perfect match with the index is 1.00, and stocks are measured in a percentage against it. The lower the beta, the less a portfolio tracks a market average, such as the S&P 500 index.
From 1926-2011, according to Ibbotson Associates, large-company stocks had a standard-deviation of about 20 percent. Small-company stocks were much more volatile over that period: 32 percent. When you look at long-term government bonds, though, volatility drops to 9.8 percent, and with a portfolio of U.S. Treasury bills, it drops to 3.1 percent.
Keep in mind that I'm referring to historical volatility; flash crashes and technical glitches such as the one that occurred on We dnesday with Knight Capital are another matter. Volatility is often unpredictable in a market increasingly dominated by high-frequency robotic trading, which often amps up market movements.
RISK VS. REWARD
Most investors can take some risk - 20 percent doesn't sound like much to most seasoned long-term investors - in exchange for beating inflation and building a decent retirement portfolio. The question then is what funds to choose.
You can be easily befuddled, since a wave of new funds emerged over the past year touting low-volatility, high-dividend stocks and lower market risk. The "low-vol" funds tend to conceptually overlap with equity-income, high-dividend and balanced offerings, which are categories of funds that have been around for years. So it's a bit of a marketing gimmick to claim that the new class of funds is any less risky than the stalwarts.
The "low volatility" moniker, especially, loses some of its punch when global market downturns happen. In those cases, since every market is reacting to what's going on in Europe, Washington and Beijing simultaneously, volatility can bruise any stock portfolio at any time. Having a portfolio of dividend-paying stocks is better than non-dividend payers, but it often skirts the fact that stocks are still much more volatile than bonds.
Low-volatility funds typically are portfolios composed of mature companies that pay consistent dividends. They are often in established industries such as utilities, healthcare, consumer staples and durable goods. You won't find many high-flying technology stocks in this pack.
When you look at popular, low-volatility offerings, though, they may reflect high correlations to the overall market. The PowerShares S&P 500 Low Volatility Portfolio ETF, for example, has a beta of 0.66, which means it's less volatile, but moves closely with the market average for large stocks, with a correlation of 0.95 (through June 30).
THE BETA DIFFERENCE
A new, emerging class of low-beta stocks does not entirely eliminate market risk - no stock fund will - but is less likely to move in lock step with the S&P 500 when it declines. The Russell 1000 Low-Beta ETF, for example, has a beta of 0.71, which means it's more than one-quarter less volatile than the Russell 3000 Index. The fund tracks an index of large-cap, low-beta stocks.
But sometimes, fund names don't always tell you the whole story on market risk. The Vanguard Dividend Appreciation ETF , with a 0.82 beta, focuses on "achievers" that have raised their dividends for at least 10 straight years.
While this is one of the lowest-risk funds in its category, it's not immune to downturns. In 2008, it lost about 27 percent, compared with a 37 percent loss for the S&P 500. The Guggenheim Defensive Equity Fund has an even lower beta - 0.57 - but lost 30 percent in 2008.
No matter what it's called, any stock fund will move with the overall market in some way. There are also other gauges that are better at measuring overall risk, such as the Sortino Ratio, which distinguishes between upside and downside volatility. So if you really want some idea on how a fund might perform in a swoon, you'll need to do some more homework.
If risk measurement is still a muddle to you, look at assets that are usually uncorrelated to stock movements, such as money market funds, U.S. bonds, metals and commercial real estate. Commodities also may be in that camp, but like Real Estate Investment Trusts, they traveled the same road south as stocks in 2008.
Want to keep it simple? Boost your bond mix while reducing stock holdings in line with what kinds of losses you can stomach. While fund names can often be confusing, straight allocations are pretty good barometers of how much stock-market risk you're taking.