Russell Low Volatility Indexes: Helping moderate life s ups and downs

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1 Russell Indexes Russell Low Volatility Indexes: Helping moderate life s ups and downs By: David Koenig, CFA, FRM, Investment Strategist February 2013 Key benefits: Potential downside protection and upside participation offers a way to help manage portfolio volatility while maintaining equity market exposure. Historically delivered lower total return variability than their parent indexes and smoother performance over time. Designed to capture pure exposure to current drivers of low volatility in today s equity market. Investor concern about market volatility in recent years has spurred interest in index-based investment strategies focused on stocks that have exhibited lower volatility historically than their parent indexes. In this environment of heightened uncertainty, investors have turned to low volatility strategies as an efficient way to help manage portfolio volatility while maintaining equity market participation. Why low volatility? Traditional finance theory regarding the relationship between risk and return suggests that higher risk, typically defined as volatility, goes hand in hand with higher expected return. Research over several decades, however, has found that low volatility strategies have historically provided lower risk without necessarily sacrificing long-term performance. 1 Various explanations have been given for this seeming anomaly, which suggests that investors tend to systematically misprice risk. One behavioral explanation focuses on a preference by some investors for so-called lottery stocks. According to this theory, investors systematically overprice high volatility stocks because of perceived outsized return potential, which may drive down expected returns on average for these types of stocks. Other explanations include the influence of institutional investment policy constraints, which has historically led to an underemphasis on low volatility portfolios because of potential tracking error relative to market cap-weighted benchmarks. Regardless of the explanation, it is important to understand that the primary objective of a low volatility index is a lower variability of returns than the parent index. Relative returns may vary depending on the market environment, but volatility would be expected to be lower in all environments. 1 Baker, Bradley and Wurgler, Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly, Financial Analysts Journal, 2011; Blitz and van Vliet, The Volatility Effect: Lower Risk Without Lower Return, Journal of Portfolio Management, 2007; Haugen and Hines, Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles, Journal of Financial and Quantitative Analysis, Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs

2 Russell Low Volatility Indexes Russell Low Volatility Indexes consist of U.S. large cap and small cap indexes that seek to deliver lower volatility than their parent Russell 1000 or Russell 2000 Indexes, respectively. These indexes use an objective, transparent construction approach designed to deliver focused exposure to portfolios of stocks with low total return variability over the last 252 trading days. Each index is weighted by inverse volatility, so that the stock with the lowest volatility has the largest weight. To help maintain consistent exposure to low volatility stocks, each index is rebalanced monthly with targeted limits on turnover. 2 Figure 1 / Key methodology features Russell 1000 Low Volatility Index Russell 2000 Low Volatility Index Number of securities Up to 200 Up to 400 Volatility definition Last 252 trading days Last 252 trading days Weighting method Inverse volatility Inverse volatility Rebalancing schedule Monthly Monthly Index inception date 5/23/2011 5/23/2011 Low volatility and risk-adjusted returns Figure 2 presents annualized returns, standard deviations and risk-adjusted returns for the Low Volatility Indexes relative to their parent indexes over various time periods ended Dec. 31, Historical performance is of course time-period dependent, but this analysis can help show how the Low Volatility Indexes have behaved in various market environments. Over the 1-year period a year of strong equity market returns in which both the Russell 1000 and Russell 2000 Indexes rose more than 16% both of the Low Volatility Indexes underperformed their parent indexes. Relative performance during the 3-year period was mixed, with the Russell 1000 Low Volatility Index slightly underperforming and the Russell 2000 Low Volatility Index moderately outperforming. Over the longer-term 5- and 10-year periods which included the highly volatile years of 2008 and 2009 both low volatility indexes outperformed. Notably, however, while the Volatility Indexes performance varied over different periods, their annualized standard deviations were lower than their parent indexes in all periods shown. Although not an explicit target, the Low Volatility Indexes exhibited standard deviations that were approximately 25% to 30% lower than their parent indexes during this period. Primarily as a result of their lower volatility, the Low Volatility Indexes produced higher riskadjusted returns (as indicated by the Sharpe ratio) than their parent indexes for most periods shown. It is again important to point out, however, that a higher Sharpe ratio may not be the case in all years particularly during strong market advances as illustrated by the slightly lower 1-year figure for the Russell 1000 Low Volatility Index relative to the Russell 1000 Index. 2 A detailed documentation of the construction methodology of the Russell Low Volatility Indexes is available on the Russell Indexes website at Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 2

3 Figure 2 / Annualized returns and standard deviations Russell 1000 Low Volatility Index Russell 1000 Index Russell 2000 Low Volatility Index Russell 2000 Index Annualized Returns (%) 1-Year Year Year Year Annualized Standard Deviations (%) 1-Year Year Year Year Sharpe Ratio 1-Year Year Year Year Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012) Low volatility during market declines One of the key benefits of low volatility strategies is the potential for smaller drawdowns during periods of severe market declines. As shown in Figure 3, the Russell 1000 Low Volatility Index drawdown of approximately 20% was less than half the 45% for its parent during the aftermath of the tech bubble in Likewise, the large cap low volatility index tempered declines during the financial crisis in , with a maximum drawdown of about 35% vs. more than 50% for the Russell 1000 Index. Figure 3 / Maximum drawdown: Russell 1000 Low Volatility Index Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012) Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 3

4 The Russell 2000 Low Volatility Index similarly produced smaller maximum drawdowns than its parent index during significant market declines, as shown in Figure 4. The small cap low volatility index experienced a maximum drawdown of a little less than 20% vs. approximately 35% for its parent in Likewise, during the financial crisis in , the small cap low volatility index had a drawdown of about 40% vs. more than 50% for the broader index. Given that a 50% decline requires a 100% gain to return to even, by moderating the downside the low volatility indexes have had less ground to make up in the wake of severe market declines. This characteristic helped the low volatility indexes keep up with the broader indexes over the long term even though they might have lagged behind their parent indexes during strong shorter-term market rallies. Figure 4 / Maximum drawdown: Russell 2000 Low Volatility Index Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012) Historical annual returns An examination of annual calendar returns helps further illustrate the historical behavior of the Low Volatility Indexes in various market environments. As Figures 5 and 6 show, over the 15-year period ended Dec. 31, 2012, the Low Volatility Indexes experienced their largest outperformance or underperformance in what could be characterized as extreme markets. The Russell 1000 Low Volatility Index produced its strongest outperformance during significant market declines particularly during 2002 and 2008 when the parent index fell by more than 20%. In exceptionally strong markets such as 1999 during the tech bubble and 2009 amid the rebound from the severe decline of 2008 the large cap low volatility index tended to underperform. In less extreme markets, returns were approximately in line with the parent index. Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 4

5 Total return (%) Total return (%) Figure 5 / Calendar-year total returns: Russell 1000 Low Volatility Index vs. Russell Outperformance historically amid market pullbacks Russell 1000 Low Volatilty Index Russell 1000 Index Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012) The Russell 2000 Low Volatility Index generally showed similar characteristics over the 15-year period as its large cap counterpart. The small cap low volatility index significantly outperformed amid the weak markets of and The small cap low volatility index underperformed in years of strong market advances, and performance was again generally about in line with the parent index during more moderate years. Figure 6 / Calendar-year total returns: Russell 2000 Low Volatility Index vs. Russell Outperformance historically amid market pullbacks Russell 2000 Low Volatilty Index Russell 2000 Index Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012) Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 5

6 Down Capture / Up Capture (%) Up capture vs. down capture An examination of up/down capture ratios, or how much of the return of the parent indexes on average was captured by the Low Volatility Indexes on days when the parent index rose vs. days when it declined, helps illustrate the potential for smoother performance over time from the Low Volatility Indexes. As Figure 7 shows, over the 15-year period ended Dec. 31, 2012, the low volatility indexes experienced a tighter average range of returns relative to their parent indexes. Notably, however, both low volatility indexes tended to capture a bit more of the upside than the downside of their parent index over this period. Figure 7 / Up Capture vs. down capture Russell 1000 Low Volatility Index vs. Russell 1000 Index Russell 2000 Low Volatility Index vs. Russell 2000 Index Source: Zephyr StyleADVISOR, Russell Investments (12/31/ /31/2012). Upside and downside capture ratios measure how closely a fund tracks positive or negative benchmark returns. Each measure is calculated as the annualized return of a fund on only the set of days when the benchmark return was positive (negative) divided by the benchmark s annualized return on the same set of days. Index performance is for illustrative purposes only. One cannot invest directly in an index. Past performance is not a guarantee of future results. Chart includes back-tested simulation and actual returns after inception on May 23, Sector Exposures The dynamic nature of the Russell Low Volatility Indexes is reflected in the changing sector exposures over time, as illustrated in Figures 8 and 9. Changes in sector exposure are driven by the indexes identification of where volatility is currently occurring in the market. The potential benefit of this dynamic approach can be seen in the narrowing financial services exposure leading up to the financial crisis. This is particularly evident in the large cap low volatility index as major U.S. banks and other large financial services companies were among the firms experiencing the greatest stresses during this period. Notably, sector exposures for the Russell Low Volatility Indexes have historically been diversified across sectors rather than highly concentrated in one or two sectors, as with some low volatility strategies. For example, as of Dec. 31, 2012, the Russell 1000 Low Volatility Index had sizable exposure to the generally more defensive Consumer Staples and Utilities sectors, but it also included substantial exposure across sectors such as Health Care and Producer Durables. Likewise, the Russell 2000 Low Volatility Index had a large exposure to the Financial Services sector, due to several relatively stable Real Estate Investment Trusts (REITs), but also diversification across Utilities, Consumer Discretionary and other sectors. As drivers of volatility shift in the market, the Russell Low Volatility Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 6

7 Indexes are designed to dynamically maintain exposure to those sectors exhibiting low volatility through their regular monthly rebalancing. Figure 8 / Sector Exposures: Russell 1000 Low Volatility Index 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Consumer Discretionary Consumer Staples Energy Financial Services Health Care Materials & Processing Producer Durables Technology Utilities Source: Russell Investments (12/31/ /31/2012) Figure 9 / Sector Exposures: Russell 2000 Low Volatility Index 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Consumer Discretionary Consumer Staples Energy Financial Services Health Care Materials & Processing Producer Durables Technology Utilities Source: Russell Investments (12/31/ /31/2012) Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 7

8 Conclusion Low volatility investment strategies have gained increasing interest in recent years as investors have faced the challenge of managing risk in a highly volatile market environment. Russell Low Volatility Indexes are rules-based, transparent indexes designed to give investors an efficient way to gain exposure to U.S. large cap and small cap stocks with low total return variability. These indexes have historically delivered lower volatility than their parent indexes and smoother performance over time. As a result of this lower volatility, Russell Low Volatility Indexes have also delivered strong long-term risk-adjusted returns. As part of a diversified multi-strategy portfolio, investment strategies based on the Russell Low Volatility Indexes offer investors a way to potentially help manage portfolio volatility while maintaining strategic equity market allocations based on their individual investment objectives and tolerance for risk. Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 8

9 About Russell Indexes Russell s Indexes business began in 1984 to accurately measure U.S. market segments and track investment manager behavior for Russell s investment management and consulting businesses. Today, our series of U.S. and global equity indexes reflect distinct investment universes including asset class, geographic region, capitalization and style with no gaps or overlaps. Russell Indexes offers more than three dozen product families and calculates more than 80,000 benchmarks daily covering 98% of the investable market globally, 83 countries and more than 10,000 securities. Approximately $3.9 trillion in assets are benchmarked to the Russell Indexes. For more information about Russell Indexes call us or visit Americas: ; APAC: ; EMEA: Disclosures Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a part of London Stock Exchange Group. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Index performance is for illustrative purposes only. One cannot invest directly in an index. Past performance is not a guarantee of future results. Chart includes back-tested simulation and actual sector exposures after index inception on May 31, This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments All rights reserved. First use: February Revised: February CORP Russell Investments // Russell Low Volatility Indexes: Helping moderate life s ups and downs / p 9