The past couple of years has seen a proliferation of smart beta exchange traded funds (ETFs).
Among these, low-volatility funds have attracted significant interest from investors seeking equity market exposure with some downside protection built-in. Low volatility strategies have been particularly popular among those investors who, having been burned by the 2007-2008 market crash, are still wary of high price fluctuations but need to go back into equities for the long-term capital appreciation that this asset class usually brings.
According to academic studies, low-volatility indices outperform the market in the long term, and with higher risk-adjusted returns to boot. Taken at face value, this counter intuitive finding sounds very compelling. However, it can be misleading. Low-volatility stocks can also experience periods of underperformance. As such, funds that track against these indices present potential risks that need to be understood.
Perhaps the biggest risk worth highlighting is sector concentration. Low-volatility themed funds tend to be highly concentrated in defensive stocks. Take the example of three European ETFs that offer controlled-risk exposure to the S&P 500: the SPDR S&P 500 Low Volatility ETF, the Ossiam ETF US Minimum Variance NR, and the iShares S&P 500 Minimum Volatility ETF. As their names suggest, they all follow different methodologies, and this results in significant differences in sector and stock allocations relative to the S&P 500.
With a 64 per cent combined weight in utilities, consumer staples and healthcare stocks, the SPDR ETF has the strongest concentration in defensive sectors, followed by the Ossiam and iShares ETFs with roughly 52 per cent and 42 per cent each. This compares to a 27 per cent weight in defensives for the S&P 500.
Needless to say, differences in sector and stock composition relative to the main benchmark mean that the funds will deliver different returns depending on the market environment. When defensive stocks are in favour over cyclical stocks, low-volatility ETFs should be expected to outperform. This phenomenon has certainly held true so far this year. Due to its heavy defensive bias, the SPDR S&P 500 Low Volatility ETF has gained 12.8 per cent since January; faring better than rivals Ossiam, with a return of 12.6 per cent, and iShares with a return of 11.9 per cent, as well as the S&P 500 index with a 10.6 per cent increase in the same period.
However, where a strong bull market takes hold and defensive stocks go out of favour, these low-volatility funds will likely underperform, with the SDPR ETF likely to be affected the most.
Because of the substantial inflows that we have seen lately into low volatility stocks, there is growing evidence when looking at fundamentals that these stocks are becoming overvalued. Thus, purely from a timing point of view, this might not be the best moment to invest in this segment of the market. At the first sign of a strong market rally, it can be easily predicted that investors will rush out of it as quickly as they got in.
