Are low volume investments good hedges?


Investors who hoped their alternative investments would provide protection against market volatility in September wondered if their glasses were half full or half empty. Only one of our benchmark ETFs recorded a gain last month and that outlier was the ProShares Short S&P 500 ETF (SH) a free kick mirror image of the S&P 500. On average, our alternative ETFs lost 3.9% of their value in September. Although this is a much smaller loss than the 9.2% suffered by the SSgA SPDR S&P 500 ETF (SPY), it was still a debit.

As seasoned portfolio builders know, hedging protection results from a combination of leverage, correlation and volatility. There is no leverage in our list of alternative ETFs (see Figure 1), so correlation and volatility are the most critical variables when considering any of them as portfolio supplements.

As an asset class, one could imagine that hedge funds are “low volatility” investments. In September, SPY, our market proxy, posted an annualized volatility of 12.6%. Meanwhile, the median standard deviation of alternative portfolios was only 7.9%. Effective hedges, among other things, tend to match target market volatility.

A hedge must also be negatively correlated to its target. Much of the poor alt performance over the past month can be explained by correlation. Only three of our alternative portfolios were negatively correlated to the general stock market in September: the aforementioned ProShares bear fund, the Invesco DB G10 Currency Harvest Fund (DBV) and the ETF ProShares Inflation Expectations (RINF).

The alternatives are not for everyone. Investors uncomfortable with alternative investments often opt for low-volatility versions of their main exposures in hopes of protecting themselves from market insults. And, under normal circumstances, low-volatility funds tend to achieve better Sharpe ratios and lower drawdowns than their full-exposure relatives. There are times, however, when low volatility funds surprise unwitting investors with significant losses.

According to Akhil Lodha, founder and CEO of StratiFi, a provider of risk management technology for investment advisers, low-volatility funds can present high tail event risk.

“Tailing events are those that fall outside the normal distribution of returns,” says Lodha. “They can happen suddenly and without notice and they often have a big impact on portfolios. During such events, the correlation tends to go towards 1. This can lead to unexpected losses.

Lodha cites the performance of the Invesco S&P 500 Low Volatility ETF (SPLV) as the first example.

SPLV has posted an annualized volatility of around 11% since its inception in 2011, while the annualized volatility of the SPY portfolio has historically hovered around 14%. With numbers like that, investors would probably think the SPLV would be less risky than the SPY. SPLV, however, acted out of character during the COVID-19 selloff in early 2020, falling 35.8% against a contemporaneous loss of 33.7% in the S&P 500.

“Some other funds like the iShares MSCI United States Minimum Volatility Factor ETF (USMV) have performed similarly,” says Lodha, “so investors who choose these funds based on volatility and hope to cut losses relative to the S&P 500 during such events may end up being surprised.

Over the past two years, large-cap, low-volatility ETFs have performed quite well relative to SPY. The largest of these portfolios are highlighted in Figure 2. The low volatility portfolios, for the most part, generated better returns with less volatility than the benchmark SPY fund.


Despite significantly reduced volatility (read: standard deviation of returns), these funds may still present investors with other risks.

Most investors, and unfortunately many advisors, assume that returns are normally distributed along a bell-shaped curve. But, in reality, returns are most often asymmetrical to one degree or another. Asymmetry refers to the asymmetry of an investment’s return. A positive asymmetry indicates that the tail of a distribution curve is longer on the right side. This means that the outliers in the distribution curve are further to the right and closer to the mean on the left. A positive asymmetry tells an investor to expect frequent small losses and a few large gains, while a negative asymmetry indicates complementary probability. Note that the asymmetry exhibited by the ETFs in Figure 2 is universally modest, although the low volume portfolios are positive while the benchmark SPY fund is negative.

Then there’s flattening, or more definitely over-flattening, which describes the “fat” of tails in distribution curves. A thick tail means there are a lot of outlier returns. Excessive flattening values ​​of 1 and above or -1 and below represent significant deviations from normal. Negative values ​​indicate finer tails than those found in normal distributions, while positive readings indicate fatter tails. Note the shallow depth of the left tail for the USMV and the heaviness of the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) straight tail implied by their flattening statistics, two important signals for cautious investors.

Figure 3: Performance of Low-Volatility, Large-Cap ETFs (September 2020 – September 2022)


StratiFi’s Lodha believes that measures such as skewness and flattening explain more of an investor’s risk exposure than volatility alone. “Volatility averages downside and upside moves, ignoring asymmetry and not appropriately weighting flattening, giving investors an incomplete sense of the level of risk,” he says. “When it comes to succinctly explaining risks, visualization is key. By using tools like StratiFi’s PRISM Rating, financial advisors can provide their clients with a clear and concise view of the risks inherent in their portfolios.

Lodha admits that many low volatility funds are not designed to deal with tail event risk. “It can be fine as long as investors are aware of this risk and what it means for them,” he says.

So what should investors and their advisors keep in mind when considering portfolio allocations? Extreme risk or volatility?

It depends.

“I think the most essential and telling measure of risk an advisor should consider is the one that’s most appropriate for the purpose,” says Lodha. “If an advisor’s goal is to protect a portfolio against losses during a stock market crash, then a metric like tail event risk would be more relevant than volatility.”

Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was responsible for marketing, research and education for the options market of Pacific Exchange (now NYSE Arca) and the iShares complex of exchange-traded funds.


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