Low volatility ETFs have become the rage lately. Powershares started the fad back in May of 2011 with their S&P 500 Low Volatility ETF (NYSEARCA:SPLV). The SPLV invests in the 100 stocks within the S&P 500 that have had the lowest volatility during the last 12 months.
iShares jumped on the bandwagon in October 2011 by launching four minimum volatility ETFs:
MSCI USA Minimum Volatility Index Fund (NYSEARCA:USMV): selects 124 low volatility securities from the MSCI USA Index. This will be primarily large and mid-cap US stocks.
All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV): selects 279 low volatility securities from the MSCI ACWI Index. This index covers 45 developed and emerging market countries. The top five countries are the US, Japan, Canada, Switzerland, and Taiwan.
MSCI EAFE Minimum Volatility Index Fund (NYSEARCA:EFAV): selects 173 low volatility securities from the MSCI EAFE Index. This index focuses on Europe, Australia, Middle East, and Far East. Overall it includes 22 developed countries but excludes the US and Canada. The top five countries are the UK, Japan, Switzerland, Hong Kong, and Singapore.
MSCI Emerging Markets Minimum Volatility Index Fund (NYSEARCA:EEMV): selects 211 low volatility securities from the MSCI Emerging Market. This index covers 21 emerging market countries. The top five countries are Taiwan, China, South Korea, Malaysia, and South Africa.
Over the last few months, the number of Exchange Traded Funds has exploded and today there are more than 30 low volatility products from which to choose.
The question is: do the low volatility ETFs live up to their hype?
To answer this, I analyzed the five oldest low volatility ETFs and compared their overall return versus risk (i.e. volatility) to their normal volatility peers. I did not consider the newer offerings since they have little or no track record. My data look back period started on 18 October, 2011; the date when the low volatility iShares began trading. Using the Smartfolio 3 program, I calculated the annualized rate of return in excess of the risk free rate of return (called Excess Mu on the charts) and plotted this against the historical volatility for each ETF.
In addition to plotting the low volatility ETFs, I also plotted the Excess Mu versus Volatility for similar peer ETFs that did not try to minimize volatility. The comparisons were as follows:
SPLV and USMV were compared to SPDR S&P 500 (NYSEARCA:SPY) to obtain a comparison to stocks in the S&P 500 Index.
ACWV was compared to the Vanguard Total World ETF (NYSEARCA:VT) to obtain a comparison for a worldwide index.
EFAV was compared to MSCI EAFE ETF (NYSEARCA:EFA) to obtain a comparison for stocks in Europe, Australia, Middle East, and the Far East.
EEMV was compared to MSCI Emerging Market ETF (NYSEARCA:EEM) to obtain a comparison for emerging market stocks.
The results are shown in Figure 1. In each case, the low volatility ETFs lived up to their hype and did indeed deliver a volatility significantly lower than their respective non-minimized peers. However, the return associated with the low volatility offering was generally lower than their peers (as you would expect) but not always. EEMV actually delivered a higher return at less volatility than EEM! A pretty surprising result.
So low volatility ETFs do reduce risk. But is the reduction in risk worth the reduced rate of return?
To gain insight into this, I divided the Excess Mu by the volatility to obtain the Sharpe ratio for each of the ETFs. This data is summarized in Figure 2. For the US market, both SPLV and USMV had a substantially better reward to risk than the SPY. Similarly all the other low volatility ETFs had a better Sharpe ratio than their peers.
Conclusion: Low volatility ETFs lived up to their billing and should be considered as a lower risk technique of obtaining exposure to both domestic and worldwide markets. No wonder they have become so popular!