Low Volatility Funds Outperform In 2016

| About: PowerShares S&P (SPLV)


The Low Volatility Anomaly describes the long-run risk-adjusted outperformance of lower risk strategies.

These strategies have provided downside protection across capitalization sizes and geographies in the weak start to 2016.

The article then demonstrates that these strategies still generate strong enough performance in bull markets to produce long-run outperformance with a return comparison from the 2009 lows.

In July and August of 2015, I wrote an expansive series of fourteen articles on the Low Volatility Anomaly, or why lower risk investments have outperformed higher risk investments over time. This Anomaly seems paradoxical; investors should be paid through higher returns for securities with a greater risk of loss. Across different markets, geographies, and time intervals, the series shows that higher beta investments have not delivered higher realized returns and offers suggestions backed by academic research to suggest why this might be the case.

We are in another period where lower volatility stocks are dramatically outperforming higher beta stocks, and this article will demonstrate the relative performance of these strategies year-to-date. I will demonstrate the relative performance across capitalization sizes (large cap, mid-cap, and small cap equity) and other geographies (international developed and emerging markets).

Readers may counter that, of course, lower risk stocks are outperforming in a down market, so I will show relative performance of the indices underpinning these strategies back to the March 2009 cyclical lows. If lower volatility strategies capture less upside in bull markets, then perhaps their value in corrections is overstated. Let's look at the evidence.

Year-to-Date Performance: Large-Cap

Thus far in 2016, the two most popular low volatility exchange-traded funds, the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV) and the S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) are handily beating the S&P 500 (NYSEARCA:SPY), the broad domestic equity market gauge. Through Friday's close, the S&P 500 has generated a -8.46% total return while the most popular low volatility funds have lost just over three percent. Relative performance is graphed below:

Source: Bloomberg; Standard and Poor's

Year-to-Date Performance: Mid-Cap

Mid-cap stocks have further underperformed large cap stocks thus far in 2016 with the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) producing a -9.57% return. The low volatility subset of this index, replicated through the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV) has also meaningfully outperformed in 2016, besting the mid-cap and large cap indices. For a historical examination of the risk-adjusted returns of this index, see my article on "The Low Volatility Anomaly: Mid Caps".

Source: Bloomberg; Standard and Poor's

Year-to-Date Performance: Small Cap

Like both large and mid-cap stocks, the PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA:XSLV) has meaningfully outperformed the S&P 600 SmallCap Index ETF (NYSEARCA:IJR). While the exchange-traded fund has a limited history (February 2013 inception date), the underlying index has data back for twenty years, demonstrating a return profile that would have bested the S&P 500 by nearly four percentage points per annum with lower variability of returns. This fund may deliver both the "size premia" and the "low volatility anomaly" in one vehicle, and has acquitted itself decently (543bp outperformance versus small caps and 307bp outperformance versus the S&P 500) in a rough market start to 2016. For a historical examination of the risk-adjusted returns of this index, see my article on "The Low Volatility Anomaly: Small Caps".

Source: Bloomberg; Standard and Poor's

Year-to-Date Performance: International Developed

Negative equity market performance has obviously not been unique to the United States amidst a global sell-off. The PowerShares S&P International Developed Low Volatility Portfolio (NYSEARCA:IDLV) has outperformed non-US developed markets, besting the Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU) by 450bp in 2016.

Source: Bloomberg; Standard and Poor's

Year-to-Date Performance: Emerging Markets

Pressured by the spillover from decelerating Chinese growth, commodity market sensitivity, and increased market and currency volatility, emerging markets have been a focal point for stress in 2016, but the PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEARCA:EELV) has meaningfully outperformed the two largest emerging market exchange traded funds - the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) and the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM).

Source: Bloomberg; Standard and Poor's

In past articles, I have often demonstrated the efficacy of Low Volatility strategies by showing the relative outperformance of the S&P 500 Low Volatility Index (NYSEARCA:SPLV) versus the S&P 500 and S&P 500 High Beta Index (NYSEARCA:SPHB). The Low Volatility bent produces both higher absolute returns and much higher risk-adjusted returns.

Readers might look at these cumulative total return graphs and believe they can time the points at which high beta stocks outperform. From the close of the week at the cyclical lows in March 2009 to Friday's close, the Low Volatility Index has also outperformed on an absolute basis.

In a long bull market that saw 16%+ annualized returns, you have not conceded performance when including the recent correction. In addition to less variable returns over time, low volatility strategies also afford more downside protection - an important feature that has been valuable in early 2016.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPY, SPLV, USMV, VWO, IDLV, XSLV, IJR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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