Low Volatility Funds Are Tested: We Have A (Surprise) Winner

Summary

• Low volatility for 2017 has been followed by high volatility in 2018.
• Low-volatility funds are among the most popular of the "smart beta" offerings on the market.
• The markedly different volatility periods give us a chance to compare how the low-volatility funds compare over different market conditions. I look at domestic large-, mid- and small-cap offerings.
• One fund emerges as a clear winner in the large-cap category. It's not one many would have expected to do so.
• Mid-cap and small-cap categories offer quite different results.

Low Volatility Funds Are Tested And We Have a (Surprise) Winner

Volatility

As we all know, that one word covers the huge change in market action from 2017 to 2018. Moderate levels of volatility in 2016 were followed by 2017’s exceptionally low volatility. In 2018 we’ve seen a turn to much higher volatility.

Over the last few years, factor investing has become increasingly trendy, and one of the cornerstones of factor investing is the low-volatility factor. It has been widely documented that the low-volatility premium has been a clear generator of alpha. Factor-based or so-called smart-beta funds hit the market as fund sponsors moved to meet investor demand for the category. Low-volatility ETFs are a prominent example.

The marked shift in volatility gives us an opportunity to ask how well the low-volatility funds have performed in both a low-volatility environment (2017) and its extreme opposite (2018 YTD). With this article I’d like to approach this question for domestic funds. As it happens, I’m writing this in-flight using data I downloaded over the past weekend, so the results I’ll be discussing are current through Friday, April 6’s close. Some of the performance data cover through the close of 2018’s first quarter.

The funds I’ll be looking at include several large-cap ETFs, one mid-cap ETF, and two small-cap ETFs . I’ve also added an open-end mutual fund that is not explicitly a low-volatility fund but one that takes a low-volatility stance to achieve a defensive market positioning. I’ve written about this fund previously (here) and felt it fit this category well enough to include here.

Eight Low-Volatility Funds

Large-Cap

AQR Large Cap Defensive Style N (AUENX)

Fidelity Low Volatility Factor ETF (FDLO)

iShares Edge MSCI Min Vol USA ET (USMV)

PowerShares S&P 500 Low Volatility Portfolio (SPLV)

SPDR Russell 1000 Low Volatility ETF (LGLV)

Mid-Cap

PowerShares S&P MidCap Low Volatility Portfolio (XMLV )

Small-Cap

SPDR Russell 2000 Low Volatility ETF (SMLV)

PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA:XSLV)

I’ll compare these funds to broad-market ETFs as benchmarks: SPDR S&P 500 ETF Trust (SPY), SPDR S&P MidCap 400 ETF (MDY) and SPDR S&P 600 Small Cap ETF (SLY) for large-, mid- and small-caps, respectively.

The funds range in size from the giant USMV (at almost $1.4B AUM) to the tiny FDLO ($55M).

Volatility

Let’s start with a look at how well the funds meet their low-volatility objectives. The next charts show daily volatility (30 days) relative to the benchmark, broad-market ETFs.

The large-cap funds all followed a similar pattern. Volatility typically tracked below that for SPY. For the low-volatility period that characterized the market in late 2017 the differences were trivial, but when volatility took off in February 2018, the low-volatility funds showed trueness to their objective. All saw volatility jump, of course, but all tracked well below SPY. LGLV was least effective at keeping volatility low. From late 2016 through early 2017, a period of low volatility for the broad market, LGLV experienced volatility at levels well above SPY to a range not seen by any of the funds until the upsurge in volatility began in February 2018.

The small-cap funds were, as expected, more volatile than the large-caps, and the small-cap, low-volatility funds had a more difficult time reining in the volatility of 2018. While they did track below the benchmark SLY, the differences between the low-vol funds and the benchmark were appreciably less than that for their large-cap counterparts.

XMLV, the sole mid-cap, low-volatility fund was the best of the category at holding volatility below its broad-market counterpart. It remained consistently below the benchmark fund, even in the low-volatility period of late 2017 when the other funds saw the gap between their volatility and that of their benchmark close.

Performance

Now that we’re satisfied that the funds generally meet their objective of providing lower volatility exposure to the market, the next questions are: Did meeting that objective generate alpha? Were the funds more successful in low- or high-volatility markets?

For the period Jan, 2016 through Mar, 2018 the only fund to post CAGR better than its market benchmark ETF was AUENX. It also posted the highest best year and best (and one of only two positives) worst year in the set. As a large-cap, defensive fund, AUENX does use low-volatility among other criteria to achieve its objectives, but as I stated above, it is not explicitly a low-volatility fund. I would, however, argue that most low-volatility investors consider that allocation to be part of a defensive slant in their portfolios.

What we do see is lower standard deviations (as we could have predicted from the volatility charts above) from the low-volatility funds in all three cap-size categories.

For the large-cap funds, only AUENX posted a better Sharpe Ratio although two other funds (USMV and LGLV) did beat SPY for Sortino Ratio. And every low-volatility fund had a lesser maximum drawdown than its full-market counterpart

XMLV, the mid-cap, low-vol fund, was arguably the most successful of the low-volatility funds. Its CAGR missed the market funds’ mark by only 55 bps with a standard deviation much more below its market standard than any of the other funds. So not only is XMLV the best of the domestic low-volatility category at meeting the low-volatility objective, it is also comes the closest to generating alpha from that factor slant for any of the ETFs.

The low-volatility small-cap funds were arguably the least successful. Small caps had a strong period (2016 was a strong, turn-around year for small caps). Two of the three funds lead the entire set in CAGR and all three lead for best year. XSLV had the best year overall although it also suffered the deepest losses for the worst year metric and the deepest maximum drawdown. But low-volatility was not a successful strategy in the small-cap universe.

The next charts show total return for low-volatility 2017 and high-volatility 2018 YTD.

Looking at 2017 we see no advantage to the low-vol funds in the low-volatility year. Large-caps were more successful than mid- or small-caps, but none of the low-volatility ETFs managed to beat SPY. AUENX did beat but only by a trivial margin. Similarly, in the smaller cap categories the broad market funds posted better returns than the low-volatility ones.

The high volatility that has characterized 2018 through the first week of April presents a different picture in two of the three categories. SPY posted a -2.3% loss for the period. Only FDLO did worse among the low volatility funds, although none was in positive territory. Defensive AUENX was the best of the large-cap losers at -0.8%. Mid caps have a similar story: no winners but less of a loss from the low-volatility fund. Small caps are the big exception. The broad-market index fund was the only gainer for the period, while the low-vol ETFs were the two biggest losers among all funds.

This is, of course, limited data, too limited to draw any real conclusions. But these limited data do indicate no real advantage to the low-volatility funds for the low-volatility year, and only a minor advantage in the high-volatility quarter. And, for small caps the high-volatility period strongly favored the most volatile fund in the set. If this high-volatility environment continues, and I fully expect that it will, we will get the opportunity to extend the test to a more informative time period.

The Winner

AUENX emerges as the real star of this group. As a defensive fund, we’d hope to see it do less badly in the negative market YTD 2018, but even in the strong market of 2017, AUNEX was a SPY-beater. But we knew it would be. When I wrote about the fund a year ago, I told you that it was beating both SPY and USMV since its inception. That run continues.

If you’re looking for something with a strong defensive stance in the current market, AUENX should be a strong candidate. It has an unfortunate million-dollar minimum for new investment, putting it beyond the reach of most retail investors in taxable brokerage accounts. But many brokers (Fidelity for one, but readers pointed out others when I wrote about it last year) will open a new position in an IRA for as little as $2,500.

And it is a low-volatility fund. From the fund’s fact sheet: “The Fund seeks to provide exposure to the U.S. stock market with lower volatility than its stock market benchmark. The Fund’s strategy seeks to provide downside protection with upside potential through active stock selection, risk management and diversification.”

Regular readers will know that I’m reluctant to make recommendations. My preference leans much more toward laying out facts and letting readers decide how those facts interface with their strategies and objectives. But in this case I have no hesitation in recommending AUENX to anyone looking for a low-volatility, defensive fund in an IRA.

Analyst’s Disclosure: I am/we are long AuENX FDLO USMV. 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.

I am not an investment professional and nothing I write here should be taken as professional advice. Everyone's personal situation is unique. It is the role of finance professionals to provide advice in the contexts of an individual's personal situation. What may be right for my investment goals and risk tolerances may well be quite wrong for someone else. Do your own due diligence. Consult with professionals on your own needs, objectives and tax circumstances before you invest. I do not give advice and ask that readers refrain from asking for it.