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Are Low-Volatility ETFs For Real?

THIS IS A REPRINT OF AN ARTICLE THAT ORIGINALLY APPEARED AT LEAST 72 HOURS AGO ON FORBES.COM

Any equity investor who wasn't thinking about volatility before is almost certainly focused on it now. Bull markets? We get it. Bear markets? We hate them, but for better or worse, here, too, we get it. Flash crashes? Even those, we at least have learned to recognize for what they are. But the sort of roller coaster we've been experiencing lately, how on earth do we play those? Everything is easy to evaluate in retrospect. But before the fact, when we must make our decisions, we still seem lost. Some nouvelle ETFs think they have an answer.

Back to Basics - Oops I Mean Beta

As discussed in an 8/11/15 post, Beta is a well-known Nobel-Prize-pedigree indicator that tells us how volatile and asset is relative to a benchmark (e.g., such as the S&P 500 if we're talking about equities). A beta of 1.00 means the asset is exactly as volatile as the benchmark. A beta of 1.30 means the asset is 30 percent more volatile than the benchmark. A beta of 0.90 means the asset is 10% less volatile.

Note: None of these ETFs are disclosing their secret sauces, nor should we expect them to. I have no idea which ETFs, if any, actually use Beta as part of their modeling. I'll be using it here, not as a predictor of anything but as a tool to evaluate what's been accomplished in the past.

Risk reduction, low beta, is not supposed to be a free lunch. According to theory (hard-core theory with that Nobel Prize aura) there's supposed to be a risk-reward tradeoff. As you reduce risk, you're presumed to be reducing your expected returns. Expected returns must always positive. (Who in this galaxy deliberately invests to lose money?) We make the tradeoff by accepting a lesser positive return than we think we could otherwise get if we were to be more aggressive.

ETF Providers On the Job

In a way, it's amazing it took ETF providers as long as it did to come up with low-volatility offerings (note the inception dates below), but whatever, at least the cavalry is here - maybe.

Table 1

Ticker

Fund

Inception

Assets ($ mill.)

Avg. $ Traded (60 days)

$CFA

Compass EMP US 500 Volatility Weighted

7/2/14

8.7

53.0

$LGLV

SPDR Russell 1000 Low Volatility

2/21/13

27.8

146.1

$SLOW

ALPS ETF Trust ALPS Sector Low Vol

7/1/15

2.4

16.5

$SMLV

SPDR Russell 2000 Low Volatility

2/21/13

32.4

156.2

$XMLV

PowerShares S&P MidCap Low Volatility

2/15/13

108.8

517.0

$XSLV

PowerShares S&P SmallCap Low Volatity

2/15/13

112.3

628.3

First off, this is not an exhaustive list. For one thing, it's U.S. only. For another, new ETFs are still coming out. Compass EMP in particular seems to be in the process of building what could become an interesting low-volatility product line. But right now, it's still getting off the ground. And even beyond that, all of these ETFs are pipsqueaks.

Strictly speaking, small size shouldn't bother me if, as a shareholder, I'm getting satisfactory results. But we have to remember that ETFs aren't just created, they can be and sometimes have also been disbanded. I'm concerned about staying power any time the asset base is so small, there's a risk the sponsor (whose revenue is usually a percent of the assets) may decide it's no longer worthwhile to keep it going. Hopefully, they'll have enough patience to give these offerings a chance to catch on.

SPDR (which has $LGLV and $SMLV) and Invesco PowerShares ($XMLV and $XSLV) are big outfits suggesting the risk of termination may be lowest (they have plenty of other sources of revenue and can likely afford to wait a long time for this segment of the ETF market to develop. But I wonder about $CFA and $SLOW (although those are my favorite tickers; SLOW speaks for itself and presumably, CFA is, or ought to be if it isn't, homage to the Chartered Financial Analyst certification, the thing held by may who create strategies like these). It's not as if one should be at risk of losing money holding an ETF that liquidates. But I have no direct experience with this scenario and, so, don't know what inconveniences may arise.

Also in terms of analyzing them, all of the histories are woefully short. I'm more comfortable than many working with limited samples, but even I cringe here. Still, I do what I can.

Let's Live Large, At Least For Now

Today, I'm going to zero in for today on $LGLV. Its tenure is among the less intolerable. As to size, it's not as small as Compass or ALPS (firms I will monitor and discuss in more detail as they develop). And unlike the bigger funds, $XMLV and $XSLV, I suspect the Russell 1000 large-cap orientation may most appeal to those most inclined to own a fund like this (but the topic of mid- and small-cap stability remains worthwhile; I'll cover it another day).

Let's start with the obvious, how did $LGLV did in the latest "correction?" From 7/26/15 through 8/26/15, it dropped 7.37%, which is bad, but not as bad as the benchmark I used, the iShares Russell 1000 ETF ($IWB), which fell 9.65%. Yes, it's a nano-sample, and I wish it weren't. But it is what it is. The fund did what it was supposed to have done. Box 1: Check.

What about the vigorous August 26-27 recovery?

$LGLV rose 2.4% versus 6.4% for the benchmark. Hmm.

Being a low-volatility ETF, we have to expect its movements to be less pronounced than average in up markets as well as down. The degree of underperformance is a bit much. But it's only two days and the second day marked something of a catch-up: On Aug. 26, $LGLV fell 0.8% while the benchmark rose 3.8%, but on Aug. 27, $LGLV rose 3.2% versus a 2.5% gain for the benchmark. Since it would be unreasonable to expect every strategy to perform exactly on script each and every day, let's say for this nano-test that Box 2 is marked Incomplete.

I also tested $LGLV against the $IWB benchmark from its 2/21/13 inception through 7/25/15, just before the market's recent swoon. $LGLV's an annualized 14% rate of return versus 16.4% for $IWB. But here's the good part: $LGLV's beta over that period was just 0.73, and because of that modest level of risk, the fund outperformed what should have been expected (based on the low volatility) at an annual rate of 1.26% (that being the ETF's actual Alpha during the period). In other words, the Nobel-prize winning risk-return-tradeoff theory thought shareholders should have fore3fieted more than they actually did. Box 3, perhaps the most important box given that it's the longest test we can do: Check!

So yes, $LGLV delivered . . . maybe.

A Possible Fly in the Ointment

$IWB and the Russell 1000 index it tracks are market capitalization-weighted. As discussed in my recent Smart Beta post, this can add extra volatility relative to other weighting protocols that don't depend on the ever-finicky stock price.

As it turns out, the 2/15/13-7/25/15 return gap between $LGLV and a hypothetical equal-weighted Russell 1000 portfolio is narrower. The latter's annual return was 15.68%. But it's beta was 1.04 versus 0.73 for $LGLV, and its standard deviation (an absolute measure of volatility that does not depend on a benchmark comparison) was 9.67%, versus 8.08% for $LGLV.

We're Good

So yes, it looks like $LGLV has so far been making delivering on its promise. Over the course of the longest test I can presently conduct, it has delivered a very modest reduction in return combined with a meaningful reduction in volatility.

But We Can Still Go Further

Not only did $LGLV do what it said it expected to do, but based on similar evaluations, I see that the PowerShares S&P MidCap Low Volatility ETF ($XMLV) and the PowerShares S&P SmallCap Low Volatility ETF ($XSMV) also delivered. However, the SPDR Russell 2000 Low Volatility ETF ($SMLV) was OK but less so (it was fine in that the reduction in return matched the reduction theory told us to expect, but less fine in that it didn't outperform theoretical expectations theway the others did).

All told, we reach some interesting conclusions today:

If you want to reduce equity-market volatility, you can succeed.

Low-volatility investor can even get a bonus; they can reduce volatility and still give up less return than they're theoretically supposed to forfeit.

There appears to be more to a low-volatility strategy than a for-dummies level quest for low beta and/or going large cap. $XMLV and $XSLV show it's also do-able among smaller stocks, but the difference between $XSLV and $SMLV suggest that even within the same size category, there may be other things we need to be thinking about.

Next, I'll examine some of those other things. Because, as noted, the fund sponsors (rightly) preserve their intellectual property, I can't evaluate the details of what they are doing. So instead, I'll create my own low-volatility equity strategy and show how they really work.