Despite recent outperformance on the equity markets, many investors remain skeptical about diving headlong into stocks. Anemic yields, meanwhile, make fixed income an unattractive alternative. How can you reel in returns without feeling insecure? Low-volatility funds are one answer.

Why low volatility?

The Capital Asset Pricing Model (CAPM) formalizes the notion that more risk leads to higher expected returns. But historical data doesn’t support this claim, says Bruce Cooper, vice chair, TD Asset Management.

Take all the stocks on the S&P 500 or TSX and divide them into quintiles according to volatility. “If you look at long-term performance, it’s more of a flat line across the various groups of stocks—the most volatile and risky equities don’t produce better returns.”

Low-volatility funds aren’t only for conservative investors, says Bill Tilford, head of quantitative investments at RBC Global Asset Management.

“Think of cash as having zero volatility. Historical volatility for equities is 16% to 20%, depending on the time period. Bonds, on average, are 4% to 6%.”

So, in a typical portfolio there is a huge gap between bonds and equities; low-volatility funds usually have 30% to 40% less volatility than equities, which puts them at 10% to 12%. This fills the gap, he says.

Michael Cooke, head of distribution for PowerShares Canada, suggests these products should make up a significant portion of your core equity exposures. “For a Canadian investor with a balanced 60% equity, 40% bond portfolio, 50% to 75% of the equity component can be in a low-volatility strategy. You can build around it with tactical exposures to individual stocks like banks and utilities, or sector-oriented ETFs.”

Tilford suggests low-volatility funds are a strong choice for the entire equity component if you’re an ultra-conservative investor.

Kevin Gopaul, senior vice president and chief investment officer, BMO Asset Management, notes some investors are reallocating part of their fixed-income holdings into low-volatility funds.

Choosing a low-volatility fund

Chris McHaney, a portfolio manager on Gopaul’s team, says beta—a fund’s measure of volatility compared to the market as a whole— is the strongest indicator of future volatility. “We select securities that have the lowest betas relative to the broader market over a five-year period,” he explains.

Companies with the lowest betas have the highest weights in the portfolio. The top three sectors are consumer staples, financials and utilities, Gopaul says, and the result is “a more diversified portfolio than the market-cap weighted S&P/TSX Composite Index.”

Cooper’s low-volatility strategy is based on two key inputs: individual volatility and cross correlations—how individual stocks behave relative to each other. Volatile stocks that consistently move in opposite directions reduce portfolio volatility. “They wouldn’t make it into a portfolio that screened only by the volatility of individual stocks,” Cooper says, “but they might find a way into our portfolio because of this volatility-reducing diversification.”