Low Blow - Why Low-Volatility ETFs Could Prove Anything But When You Really Need Them To Be

by: The Value Perspective

By Ian Kelly

Just as nobody buys a parachute primarily for its colour - well, certainly not twice - presumably the main reason investors choose to buy low-volatility exchange-traded funds (ETFs) is safety-related. If they really were looking for a smoother ride from the share prices of their underlying holdings, though, events in global markets over the last few days may well have come as a considerable shock.

Low-volatility stocks have enjoyed a good run in recent years, and as is often the way with investment, the better an asset or sector performs, the more people want a piece of the action. The low-volatility ETF market is now considerable - to pick out one example, the PowerShares offering that tracks the S&P 500 Low Volatility Index (NYSE:SPLV) has attracted almost £3bn from investors since its launch in May 2011.

If pushed on why low-volatility stocks have done so well, here on The Value Perspective, we would raise the possibility they were priced very cheaply at the start of their run. In a previous article, "Lost and pounds", for example, we reminded you how lowly valued tobacco stocks used to be as the market fretted over, among other things, huge threats of litigation. Then, as those fears largely receded, the shares re-rated.

Once a group of stocks reach "fair value", however, the only way they can continue to outperform the rest of the market is if they grow their earnings more quickly. Where we would take some convincing then is that there is any reason why a business would be able to grow its earnings faster over the longer term just because its share price happens to bounce around a little less than the wider market does.

In other words, while a low-volatility strategy has worked in the past, we have our doubts as to whether it will to continue to do so. Where we have few doubts, however, is that many people will have been shocked over the last few days by just how volatile their low-volatility ETFs have proved since the global markets went into free fall over concerns about China.

The following chart shows how the aforementioned S&P 500 Low Volatility ETF traded versus the whole S&P 500 on Friday, August 21. While we would not normally focus on intra-day pricing on The Value Perspective, when a low-volatility ETF at one point plummets 46% as its wider benchmark drops just 7% - while trading real volumes on those numbers - we are prepared to make an exception.

(Source: Bloomberg, August 2015)

(Source: Bloomberg, August 2015)

A good lesson to take from this is the importance of, as it were, looking under the bonnet of any collective investment so you are comfortable with the sort of businesses you own through it. Anyone "popping the hood" of the S&P 500 Low Volatility Index, for example, would find an allocation of almost 15% to insurance companies and a further 13% to real estate investment trusts.

Is there any great reason why the valuations of these stocks should not be volatile over time, or in the case of insurance, the businesses themselves should not be volatile? If you accept that the valuations of these businesses and their earnings are likely to be volatile, you might ask what are they doing making up more than a quarter of a low-volatility benchmark? The answer lies in the fact that these kinds of indices, and the funds that track them, are mechanistic in nature.

Thus, the S&P 500 Low Volatility Index is set up to measure the performance of the 100 least volatile stocks of the S&P 500, with volatility defined as "the standard deviation of the security computed using the daily price returns over 252 trading days". It may seem odd for the index to have a 15% allocation to insurance companies today, but over time, ideas such as low volatility can become self-fulfilling.

There will be times when this sort of strategy works and times when it does not. But you only ever get what the market is willing to pay, and at one point on August 21, for low volatility, that was half what it was the day before. To our minds, owning a low-volatility investment that fails to provide it when it is really needed is akin to a pretty-coloured parachute which doesn't open when you pull the cord.