Why do low volatility ETFs have alpha?

Posted on May 9, 2013 by


A recent white paper answers the question.

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Background: Alpha

I recently posted an article in which I illustrated how one might measure “alpha” for a security with respect to its benchmark. I’ll skip the details here (read about it at the link above), let’s just assume that if an investment has alpha, it is outperforming its benchmark in a measurable way.

I illustrated the article with an example security, SPLV, compared to SPY.  SPLV is based on a low volatility index that reflects investment in the lowest 100 volatility stocks in the S&P 500. And indeed SPLV has positive alpha against that benchmark.

Where does the alpha come from?

Besides SPLV, I have observed recently in several other instances  that low volatility versions of traditional indices have been outperforming their brethren. But to be honest I wasn’t entirely sure why. Until… A colleague just pointed me to an interesting article about alternative index ETFs and where their alpha comes from.

The article is by David Blitz of Robeo Quantitative Equity Research. You can read it here. Blitz’s lead off point is that yes, indeed there is alpha there, and it arises from a “tilt” in the index that prefers underlying factors that provide value:

The argument which is typically used to motivate smart beta investing is that the capitalization-weighted index is inefficient, and that a more efficient portfolio can be constructed by applying some alternative stock weighting scheme. We agree with this view, but we think it is important to understand where the added value of such weighting schemes really comes from. Research has shown that the weighting schemes tend to result in structural tilts towards stocks which score high (or low) on certain factors, and that the premiums which are known to be associated with these factors are driving performance.

Of particular interest to me is his analysis of low volatility ETFs:

Low-volatility indices are designed to benefit from the low-volatility premium: the empirical finding that low-risk stocks have similar or better returns than the market average, with substantially lower risk.

the S&P 500 Low Volatility index, which simply invests in the 100 stocks in the S&P 500 index with the lowest volatility over the preceding twelve months.9 Empirical studies have shown that this simple ranking approach results in a very similar risk-return profile as more sophisticated optimization approaches.

He examines several other sorts of tilts that arise from various types of alternative indices, and the pros and cons of each:

  • Fundamental indices
  • Low volatility indices
  • Max Sharpe Ratio indices
  • Momentum indices
  • Equally weighted indices

And finally, an important point he makes, that I firmly agree with

Even though these ETFs are based on indices, they’re not passive: They represent active management

 it is important to realize that their deviations from the capitalization-weighted index, which are the key to their added value, represent active investment decisions.

One final point to make: Blitz’s article is really a critique of these ETFs. To some extent he’s pointing out that if one wants to capture the factor premium that these EFTs tilt towards, one should invest directly in that way. He may be correct about that, but it is extremely challenging for an individual investor to discover and manage strategies like that. The ETFs make it easy, and low cost.


Tucker Balch manages a fund with a long position SPLV.