Funds: Back the tortoises, not the hares

Recent studies have shown that funds comprising of low-volatility stocks often do better than riskier ones. Paul Amery explains why, and tips one reliable exchange-traded fund to buy now.

Several studies have shown that if you buy a portfolio of the lowest-risk stocks you can do better than if you invest in higher-risk shares. This seems to fly in the face of conventional wisdom. So-called benchmark tyranny' may be the root cause of this effect.

The more fund managers use broad value-weighted share indices to measure their performance, the more they are forced into chasing the market's high-flyers (internet stocks in 1999/2000, financials in 2006/2007 and Apple in 2011/2012). So bubbles form because fund managers can't afford to avoid the market's latest hot favourites. But you can play this to your advantage.

A low-volatility strategy ignores the high flyers and concentrates on those companies with more reliable earnings and yields, so-called value stocks. Over time an index based on such low-volatility tortoises may well outperform a capitalisation-weighted index that's full of hares.

Exchange-traded fund (ETF) issuers have rushed to issue low-volatility products. Last week market leader iShares launched minimum-volatility tracker funds on US, European, global and emerging-market (EM) equities with annual fees of between 0.2% and 0.4%.

The iShares MSCI EM Minimum Volatility ETF (LSE: EEMV) charges 0.4%, undercutting the firm's own ETF based on the capitalisation-weighted version of the MSCI index (IEEM, which costs 0.75%). Over ten years, says MSCI, based on a simulation, the minimum-volatility EM index has returned 20.1% a year, compared with 15.9% for the standard, market-cap-weighted index, and with reduced volatility.

My caveat here is that you should always be sceptical of backtests, especially in the case of relatively illiquid emerging markets, where stock turnover costs may not be fully reflected. MSCI's index method assumes stock turnover of 20% a year, a fairly modest figure. That said, low-volatility products are cheaper and you also get better yields: around 2.5% a year (net of fees and dividend withholding taxes, IEEM pays 1.8% by comparison).

There are some drawbacks: the MSCI's EM minimum-volatility index's constituents trade at a premium to the broader index, suggesting investors have already put a bit of a price premium on the strategy. Nonetheless, EEMV is worth a look.

Paul Amery edits www.indexuniverse.eu, the top source of news and analysis on Europe's ETF and index-fund market.

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