Low-volatility exchange-traded funds (ETFs) have become extremely popular since the 2008-2009 global financial crisis. With Brexit and other market-moving events creating uncertainty, investors have poured billions of dollars into these smart-beta funds as a way to hedge against risk and still capture market upside. The problem is that these funds are starting to exhibit some warning signs that investors should carefully consider before assuming they’re a safe bet.
In this article, we’ll look at why low-volatility ETFs have become so popular, as well as why investors may want to exercise caution before using them.
Low-volatility ETFs have become extremely popular over the past few years, as investors seek safer returns. In fact, the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV ) alone has seen nearly $1.4 billion in net inflows that have brought its market value up to $7.7 billion since the beginning of the year. The ETF has rewarded many of these investors with 10.2% returns compared to about 7.7% for the SPDR S&P 500 ETF (SPY ).
It’s easy to see why investors have flocked to low-volatility ETFs. According to Invesco, the S&P 500 Low Volatility Index captured only 43% of the S&P 500’s downside since 2011 and even managed to rise in one of the ten worst market downturns (see graph below). The iShares Edge MSCI Min Vol USA ETF (USMV ) similarly notes that it has captured a full 83% of the S&P 500’s upside and just 44% of its downside since November of 2011.
According to John Prestbo’s piece on MarketWatch, more than $50 billion has been added to low-volatility ETFs over the past five years or so since the 2008-2009 financial crisis. Six of these ETFs have attracted more than $2 billion in assets a piece, with the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV ) commanding nearly 20% of the category’s assets and the iShares Edge MSCI Min Vol USA ETF (USMV ) holding double that figure.
The significant capital inflows into low-volatility ETFs have led to concerns over the valuation of less volatile relative to more volatile equities. For instance, the iShares Edge MSCI Min Vol USA ETF (USMV ) trades with an average P/E ratio of 24.84x and a P/B ratio of 3.37x compared to an average P/E ratio of 19.69x and P/B ratio of 2.77x for the SPDR S&P 500 (SPY ). These are significantly higher valuations that could jeopardize future performance.
|Price-Earnings (P/E)||Price-Book (P/B)|
|SPDR S&P 500 (SPY )||19.69x||2.77x|
|iShares Edge MSCI Min Vol USA ETF (USMV )||24.84x||3.37x|
|Difference in Valuation||0.262||0.217|
A second concern is that the strong performance of these ETFs has actually increased their volatility relative to the S&P 500. In fact, low-volatility ETFs have been about 25% more volatile than the market. While this volatility has been skewed towards the upside, the lack of control over volatility could just as easily spill to the downside. Mr. Prestbo points out that a reversion to the mean could disillusion low-vol investors.
Finally, it’s worth noting that the expense ratios associated with low-volatility ETFs are often higher than standard market index funds. These expenses can add up over time and require the funds to outperform benchmark indexes in order to match returns – a tall order for any fund. The S&P 500 SPDR ETF’s net expense ratio stands at just 0.0945% compared to low-volatility ETFs’ expense ratios of between 0.15% and 0.25%.
The Bottom Line
Low-volatility ETFs have become extremely popular since the 2008-2009 global financial crisis as a way to reduce risk and still capture upside. While their performance has been impressive to date, there are some warning signs that investors shouldn’t ignore, including lofty valuations and rising volatility. These funds also carry higher expense ratios, which means they will need to sustainably outperform cheaper index ETFs to deliver the best returns.