By John Wasik
CHICAGO, August 2 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
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,
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
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.