March 2016: The Not-So-Passive Ways of Low Volatility Investing
The third edition of UBS ETF Factor Matters analyzes passive low volatility investing in some detail:
- Two competing frameworks have recently been developed within investible equity indices which address low volatility investing: the risk-weighted approach and the minimum volatility approach. We review in detail risk-orientated indices (incl. MSCI Risk Weighted vs MSCI Minimum Volatility), and highlight their key differentiating features. Both frameworks are accessible with the use of ETFs.
- The two frameworks are built on different foundations: the risk-weighted approach is model-free as well as optimization-free. In contrast, the minimum-volatility is model-based and uses optimization-based framework. Although both share certain similarities, there is still a considerable difference when looking at their factor attributions, i.e. the basic risk-weighted method also admits stocks with above-average volatility with virtually equal weight which drives the so-called size effect (overweight of smaller caps).
- The basic risk-weighted framework can however be slightly refined so that the selection of low volatility candidates is more dynamic (the MSCI Select Dynamic 50% Risk Weighted index). This easy-to-rationalize refinement proves to be a powerful approach for passive low volatility investing.
Previous ETF Factor Matters publications - 2015
Undervalued Healthy Stocks = Prime Value Investing
- The second edition of UBS ETF Factor Matters analyzes in some detail the value strategy: The first generation of growth and value style indices splits each respective parent index equally into growth and value sets, to cover complete market capitalization. This symmetric approach results in overlaps, thus diluting the tilt.
- The newest generation of indices (also known as alternative beta or smart beta) aims to purify exposure via more stringent selection and ranking criteria, thus weighting the most suitable stocks according to their value strength.
- We review some recently developed value indices (incl. MSCI Enhanced Value vs MSCI Prime Value), highlighting the key differentiating aspects. The wide range of available value-orientated indices requires investors to understand key differences, when deciding which strategy is more suitable.
The first edition analyzes in some detail the shareholder yield indexed strategy. Many investment strategies target high yielding stocks for income and capital enhancement, even though this is not without risk. Ideally, companies should strike the right balance between cash distributions and reinvestments to ensure future business growth. Recent index development capturing the performance of stocks with above-average dividend yield and/or buyback yield merits a comparative study. Indices differ in their construction methods, and this paper looks to shed some light on the key differences.
Particular attention is placed upon how shareholder yield is financed. The MSCI Total Shareholder Yield Index is derived from equity-debt considerations, thus building on a more holistic view of each respective company's capital structure. When seeking long-term shareholder value, the key is to focus on companies that finance dividends and/or buybacks from free cash flow, rather than from capital structure arbitrage.