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Minimum Volatility ETFs: Fact or Over-estimated Hype?

Zacks Equity Research


With the equity markets retreating somewhat from the record high levels on account of weak domestic and global cues, all eyes would be on the ongoing first quarter earnings season. By now it should be a very well known fact to the investor community that this quarter earnings are the wild card for equities going forward. This is especially in order to justify the sentiments with the fundamentals (see Retail Sales Data: The Biggest Driver of Retail ETFs).


In fact this might also be viewed upon as the much awaited correction which was long overdue. However, whether or not it is the start of the imminent correction, will be clearer in the days to come as the earnings season shifts to a higher gear.


Whatever be the situation, safety preference has also been the focus for many investors along with the optimism in equities. The first quarter itself saw massive inflows in short term bond ETFs which offers a safety play due to their low portfolio duration (i.e. the sensitivity of bond prices to changes in interest rates), given the fact that interest rates are in their record lows.


Speaking of safety, we have long mentioned in our articles the importance of low volatility products which not only reduce the overall portfolio volatility, but also go a long way in maximizing returns (read Buy These ETFs for Higher Returns and Lower Risk). Fortunately for investors, there are a number of options in the ETF space which they can utilize to gain exposure in the low volatility equity space. One of them is the iShares MSCI U.S. Minimum Volatility ETF (USMV).


USMV in Focus


The ETF is a recent addition to the massive product portfolio of iShares being launched in October of 2011. However, the reception that the product got from the investors is way beyond just any new launch. It has managed to amass an asset base of just a tad below $3 billion and on an average trades close to 278K shares daily.


As its name suggests, the product seeks to reduce the overall exposure to volatility and it does that by primarily employing a strategy that selects stocks that exhibit lower volatility characteristics. Furthermore in its attempt to reduce risk, it selects from a universe of predominantly large cap stocks and also weighs the components almost equally in order to avoid concentration/stock specific risk.


The ETF has exposure to roughly 126 stocks and charges investors 15 basis points in fees and expenses—a pretty reasonable expense ratio considering the competition and the purpose it serves (see Small Cap Japan ETFs: Overlooked Winners?).


Naturally, the ETF is largely skewed towards the defensive sectors like Healthcare and Consumer Staples. However, aggressive sectors such as Financials and Information Technology are also given a good amount of weighting. USMV also pays out 1.16% as yields.


Fact or Over-estimated Hype


It is true that any investment avenue that limits exposure to volatility and at the same time does not cap the upside potential is a very lucrative option. Especially compared to a ‘non-low risk’ avenue, which might provide similar returns, but in case of a downtrend, their relatively high variance will cause them to plunge at a faster pace (see 4 Ways to Short Gold with ETFs).


On the other hand, for the minimum variance products, even if the broader market turns south, the products will eventually plunge but at a much lower pace. This is primarily due to the low beta and low variance that these products possess.


But do these theories work in real life? We seek to find the answers with the following charts.


Chart 1: 30 Day Rolling Standard Deviation


The above chart represents the comparitive 30 day rolling Standard deviation (as a measure of volatility) of USMV and the S&P 500. The time in consideration is since the inception of USMV. As we can see, the ETF does justify its strategy as a minimum volatility product as the volatility line of USMV is almost always below the S&P 500 volatility line.


It can therefore be argued that the product well and truly limits the exposure to volatility. But what about returns? Does it significantly cap the returns potential too? The following chart seeks the answer.



Chart 2: Cumulative Daily Returns (Since the Inception of USMV)


The chart (the daily cumulative returns) suggests that the answer is ‘No’. In fact most of the times the USMV is seen outperforming the S&P 500 index. At the same time, investors should note that the time period in consideration was not a bad one for the broader equity markets either.


Therefore, for any investment avenue to establish a trend by beating the S&P 500 index within this time frame would be an excellent show. More so if the product exhibits lower realized volatility than the index (see 4 Low-Volatility ETFs to Hedge Your Portfolio).


Not only this, the product also goes a notch higher to establish a pure play low volatility ETF and establishes a trend of low beta value versus the S&P 500 index as indicated by the following chart. As we can see the beta value has never crossed 1 since its inception.


The Bottom Line


It is a fact that low volatility products have been very popular among investors. This is not only during uncertain times, but also when markets are surging. Also, another example of an ultra popular choice within the low volatility ETF space is the PowerShares S&P 500 Low Volatility ETF (SPLV). The ETF was quite recently launched in May of 2011 and has witnessed massive inflows in its asset base since inception.


At the time of writing, SPLV had an asset base of around $4.7 billion. With such enthusiasm surrounding the low volatility products one thing becomes quite clear. Going forward these low volatility ETFs will continue to be the darling of the investors (read 3 ETF Strategies For Long Term Success).


And why not, because not only have they justified their investment strategy to the full extent, but low volatility ETFs have also given investors the opportunity to earn high returns while keeping a limited view on its underlying volatility. It can therefore be safe to argue that low volatility ETFs have well and truly arrived, and are not just over-estimated hypes.

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