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(Re)balancing act

SCOTT KEFER, CFA 10-Aug-2020

balancing stones

Not all lower volatility-oriented equity strategies are created equal. After the strange days of early 2020, it has become more critical than ever to understand the methodology and composition of any ETFs marketed as low-volatility. Don’t be caught off balance. 


For example, one of the more popular “low-volatility” ETF uses a simplistic approach that first measures the trailing one-year standard deviation (a popular metric of volatility) of all the stocks in the S&P 500® Index, and then it buys the 100 least volatile names. The portfolio is rebalanced quarterly and aims to offer investors a way to stay invested in equities while lowering the odds of sharp drawdowns. 


Traditionally, this has led to massive weights in “defensive sectors,” such as utilities and REITs, which comprised approximately 50% of the portfolio at the beginning of the year. However, that all changed with the ramifications of the pandemic and the unusual volatility experienced earlier this year. This turned historical volatility upside down, and suddenly utilities and REITs were no longer low-volatility, according to the backward-looking statistics. 


Rather, the companies that turned out to have lower levels of volatility during the first half of the year included mega-cap technology stalwarts such as Google (Alphabet) and Amazon. Thus, an investor’s sleepy low-vol strategy might be buying momentum-oriented FAANG stocks, and at historic valuations no less. The recent rebalance also shifted utility and REIT exposure to healthcare and consumer staples. These amount to major changes for low-vol strategies designed to help investors sleep at night.


In light of this, investors might want to ask: 


• Will the recent change in volatility leadership last, or was it the one-off result of some extraordinary circumstances? If utilities and REITs return to the lower levels of volatility they’ve historically been known for, does this set the stage for another massive rebalancing? 


• Historically, low-vol strategies may have suffered from sector concentration in utilities and REITs, but does the shift to healthcare and staples impact an investor’s asset allocation models?


• Will the substantial turnover in the recent quarterly rebalance result in unwanted tax ramifications for investors?


• Are those ETFs rebalancing into high-profile large-cap technology names really just chasing performance? 

Simply buying the lowest volatility stocks based on backwards-facing data seems a tad simplistic. A more prudent approach might be to focus first on attractive fundamentals, and then lower volatility through portfolio construction. A bit of nuance and adhering to sector constraints might help ensure that a low-volatility approach is positioned to deliver on its objectives in all market environments, while also avoiding excessive turnover and strange portfolio composition.

©2020 Victory Capital Management Inc.