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Portfolio > ETFs

Low-Volatility ETFs Are Outperforming but Untested

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Following the initial slide in stocks after Brexit, prices jumped into record high territory while volatility collapsed. But unlike previous generations that blindly chased stocks at will because of rising prices, today’s investors, with the help of ETFs, have been more cautious.

Instead of pouring money into higher risk segments of the stock market like mid and small caps, today’s ETF investors are favoring funds that reduce market gyrations by owning stocks with less volatility.

The top five funds built to cut market volatility, including the iShares Edge MSCI Minimum Volatility USA ETF (USMV), pulled in almost $13 billion in net assets through June 30, according to Morningstar. It’s an impressive feat considering that fund investors liquidated about $52 billion in U.S. stock funds against the backdrop of slumping volatility.

ETFs that minimize stock market volatility, also known as “low-volatility” or “low-vol” funds, aim to reduce market gyrations by screening for stocks with lower betas. For example, stocks with a beta under one will generally be less volatile than the overall market. Stocks with a beta above one generally have a higher volatility. If a stock’s beta is 1.3, for instance, its volatility is expected to be 30% higher compared to the broader stock market.

USMV holds a basket of 177 publicly traded U.S. stocks including General Mills (GIS)  Johnson & Johnson (JNJ), and PepsiCo (PEP). The average equity beta for the USMV’s portfolio is just 0.68%.

Since the start of the year, the S&P 500 has gained 6.3% while the VIX – a measure of volatility – has sunk 35%. During the same period, low-volatility ETFs like USMV, along with the PowerShares S&P 500 Low Volatility ETF (SPLV), have delivered market-beating performance, gaining around 12% year-to-date, almost twice the returns of the S&P 500.

Despite the love affair with low-volatility ETFs, these products were only introduced during the aftermath of the 2008-2009 global financial crisis and have yet to face a period of chaotic markets.

Whenever new investment products are launched – and low-volatility ETFs are still relatively new – a certain element of market timing and luck is involved. Ideally, product sponsors want to release ETFs in market conditions that will benefit the fund’s strategy and performance, and that’s exactly what’s occurred with low-volatility ETFs over the past several years.

Since 2009, the VIX has been crushed and fallen almost 70% while the U.S. stock market has soared just over 200%.

Meanwhile, the first wave of low-volatility ETFs like USMV and SPLV were introduced in 2011, several years after the global financial crisis. How would they have performed during that highly turbulent period? Nobody really knows because they didn’t exist and unfortunately back-tested simulations don’t count.

More important, the stock market has enjoyed a sustained period of calm since the financial crisis. As a result, the market timing by ETF sponsors launching low volatility ETFs appears to be impeccable because thus far, these products have enjoyed life in a relatively low-stress climate.

Realistically, it’s difficult for objective investors to ascertain how well volatility-reducing ETFs will hold up in unfavorable market conditions because they lack real-world experience in those types of settings. Furthermore, the volatility surges we’ve seen in the post-financial crisis era have been too abbreviated for low-volatility ETFs to declare victory.

Advisors should be skeptical about claims that low-volatility ETFs will most certainly reduce stock market volatility in the future while simultaneously producing risk-adjusted market beating results currently. It’s entirely possible that the relatively concentrated basket of stocks being held by low-volatility ETFs may go out of favor and lag the broader stock market.

Ultimately, the real test for low-volatility ETFs won’t be when market conditions are favorable like right now, but rather when stock prices begin to crater. How will low volatility ETFs perform then? Will they soar like an eagle or sink like the Titanic? Will the additional risk of overweighting securities with lower volatility produce market-beating returns that make those risks worth it over the long run?

As the stampede into low-volatility ETFs continues, only patience and time will determine whether these strategies can deliver during an adverse market cycle of falling stock prices.

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