By Michael Rawson
Low-volatility equity strategies were all the rage two years ago. Investors were looking to tiptoe back into the equity market but could not stomach the volatility, and two newly minted exchange-traded funds were happy to meet the demand. iShares MSCI USA Minimum Volatility (NYSEARCA:USMV) and PowerShares S&P 500 Low Volatility (NYSEARCA:SPLV) raked in $6 billion in the year through April 2013. Those strong flows came at a time when overall demand for equities was tepid. The organic growth rate for large-blend funds was only about 2% during that period. Since that time, the broad equity market has rallied, and investors have pulled $3 billion out of the low-volatility funds while ramping up investment in the broader equity market. While these funds should lag during bull markets, they may pay off during market downturns. Investors who try to chase performance are likely to be disappointed.
USMV is a suitable core holding for conservative investors who want exposure to stocks with less volatility than a traditional stock portfolio. It attempts to construct the least volatile portfolio using stocks from the MSCI USA Index, under several constraints. Among these constraints, the fund limits its sector tilts within 5 percentage points of a market-cap-weighted benchmark. This constraint helps the fund avoid loading up on interest-rate-sensitive utilities. Rather than simply targeting individual stocks with low volatility as SPLV does, this fund takes into account how stocks interact with each other in its portfolio-construction process. This results in a portfolio with stocks that generate relatively stable earnings and are less sensitive to the business cycle than the broader market. Consequently, the fund should hold up better during market downturns. However, it also likely will underperform during bull markets. For example, when the market, as represented by the MSCI USA Index, was down 37% in 2008, the MSCI USA Minimum Volatility Index was only down 26%. However, in 2013, the market returned 33% while the fund posted a 25% return.
Low-volatility stocks historically have offered higher risk-adjusted returns than their more volatile counterparts, suggesting that the market has not offered adequate compensation for incremental risk. Leverage aversion may help explain this anomaly. Individual investors may be unwilling or unable to use leverage to achieve their return objectives. Similarly, most mutual fund managers cannot use leverage to boost their returns. However, they are compensated based on their performance relative to a benchmark. In order to earn higher returns, they may overweight riskier (higher beta) stocks, which theory predicts should outperform in a rising market. Their collective bet on these volatile stocks may cause them to become overvalued. Additionally, investors may also overpay for volatile stocks for a small chance of a high payoff, similar to a lottery ticket.
The historical evidence behind low-volatility investing is impressive. The back-tested MSCI USA Minimum Volatility Index had similar returns, but slightly lower risk than a portfolio with a 90% allocation to stocks and a 10% allocation to bonds from June 1988 through March 2014. Since its inception in October 2011 through March 2014, USMV has returned 17.9% on an annualized basis, compared with 21.5% for the S&P 500. However, it had a volatility of only 9.8% compared with 12.7% for the S&P 500, resulting in a slightly better return/risk ratio. During that time, the fund's beta, or sensitivity to changes in the S&P 500 Index, was only 0.7.
According to the capital asset pricing model, stocks with greater nondiversifiable risk should offer a higher expected return as compensation. In 1972, Michael Jensen, Fischer Black, and Myron Scholes found that the relationship between market risk (captured by the capital asset pricing model beta) and return was not as strong as expected, meaning that there was little extra reward for bearing incremental risk. Since then, several studies have corroborated these findings and found a similar relationship using volatility as a measure of risk.
Historically, stocks with low volatility have traded at a discount to stocks with high volatility. This makes sense because more-expensive and higher-growth stocks, such as technology or consumer discretionary stocks, tend to be more volatile than cheap, but slow-growth utilities or consumer staples. In the wake of the financial crisis, low-volatility strategies have grown popular, and several funds have launched to capitalize on investor demand. Their newfound popularity has impacted valuations, and low-volatility stocks now trade at a premium to the market based on measures such as price/earnings and price/book. Based on Morningstar equity analysts' fair value assessments of USMV's underlying holdings, stocks in the fund are trading at a price/fair value multiple of 1.01, slightly higher than the 1.00 for stocks in the S&P 500 Index.
Because stocks with low volatility have historically traded at attractive valuations, there can be some overlap between the value and low-volatility anomaly. However, this fund attempts to minimize its exposure to the value factor. It also seeks to neutralize large sector bets.
While low-volatility stocks likely will continue to offer lower risk and potentially better risk-adjusted returns than the broad market, their absolute returns may be less attractive going forward. Stocks with low volatility tend to be less sensitive to the business cycle than average, and experience slower cash flow growth as the economy expands, which is often when interest rates rise. Consequently, the fund's holdings may have less earnings growth than the broad market to offset the negative impact of rising interest rates.
The fund follows the MSCI USA Minimum Volatility Index. MSCI uses the Barra optimization and risk model to build a portfolio that is forecast to have low risk. This model requires estimates of variances and correlations for all stocks, as well as sensitivities to risk factors. USMV starts out with all of the stocks in the MSCI USA Index. The Barra optimization and risk model determines the weights, subject to constraints on individual security and sector weights. For example, the maximum stock weighting at rebalance is 1.50% and the minimum is 0.05%. Each sector will be weighted within 5 percentage points of its weight in the parent index. These constraints preserve diversification and limit the impact of estimation errors. USMV contains 138 stocks with an average market cap of $40 billion, compared with 609 stocks with an average market cap of $61 billion for the MSCI USA Index. The index is reconstructed semiannually, but turnover is limited to 10% at each rebalance. The fund charges a low 0.15% expense ratio.
PowerShares S&P 500 Low Volatility SPLV (0.25% expense ratio) has attracted more assets than USMV. Since it launched first, SPLV gained a first-mover advantage over USMV and employs a similar methodology. SPLV selects the 100 stocks from the S&P 500 Index with the lowest volatility during the past year and weights them by the inverse of their volatility. As a result, the least volatile stocks receive the largest weights. Despite this simplicity, SPLV's approach should work as well as the more complex approach USMV uses. However, SPLV may make large sector bets, whereas USMV will not.
Investors can blanket the global equity market with low-volatility strategies using PowerShares S&P International Developed Low Volatility (NYSEARCA:IDLV) and PowerShares S&P Emerging Markets Low Volatility (NYSEARCA:EELV), which levy 0.25% and 0.29% expense ratios, respectively. Both use SPLV's method for ranking and weighting stocks for their respective universes, so sector and country bets can be significant. Investors can target foreign developed and emerging markets with iShares MSCI EAFE Minimum Volatility (NYSEARCA:EFAV) (0.20% expense ratio) and iShares MSCI Emerging Markets Minimum Volatility (NYSEARCA:EEMV) (0.25% expense ratio), respectively. The all-world solution is iShares MSCI All Country World Minimum Volatility (NYSEARCA:ACWV). It charges 0.34%, which is more expensive than any combination of EFAV, EEMV, and USMV.
Because bonds help temper the volatility of stocks, Vanguard Balanced Index (VBIAX) may also be a suitable alternative to help limit risk. This fund maintains a 60/40 split between stocks and bonds. However, in contrast to USMV, it does not attempt to generate higher risk-adjusted returns.
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