Low volatility ETFs – a good investment?

May 24th, 2017 | By | Category: Equities

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Low volatility strategies have gained significant traction in Europe, fuelled by investors looking to reduce risk in volatile markets. In a new research paper, which analyses the growing popularity of such strategies, Morningstar estimates that they have racked up €27 billion of net flows since 2012, with total assets under management reaching €40bn as of year-end 2016.

Morningstar: Low volatility ETFs – are they a good investment?

Morningstar: Low volatility ETFs – are they a good investment?

A decent chunk of these assets are held in ETFs, with iShares‘ European-domiciled minimum volatility suite housing some €4 billion in AUM alone. The largest of which is the iShares Edge MSCI World Minimum Volatility UCITS ETF, with more than €1.4 billion in assets.

Interestingly, low volatility strategies have been particularly resistant in terms of flows. They still saw net inflows even when their respective conventional market-cap weighted funds experienced net redemptions. For instance, in 2016 low-volatility funds investing in European equities registered modest, but positive, net flows of €156 million, whereas the broader Europe equity categories experienced record outflows.

However, Morningstar research finds that investors in low volatility funds might be subjected to hidden costs and risks, including unwitting sector and factor tilts.

The broad range of funds studied by Morningstar show a clear bias towards smaller companies compared to the market capitalisation-weighted benchmarks. In addition to the size factor, low volatility portfolios also have greater exposure to the quality factor, with portfolios displaying a higher average level of financial health and ‘economic moat’ as measured by Morningstar.

In terms of sector breakdown of low volatility portfolios, investors should make sure they know what they are getting exposure to. There is no clear consistency between low volatility funds in their sector allocations across the different regions. This is because the majority of funds use optimisation-based techniques that enable managers to address potential risk drivers within their portfolios on a much more granular and accurate level than adjusting sector or country allocations.

On average, however, low volatility strategies are less exposed to the financial sector. Since the global financial crisis and the eurozone debt crisis in 2011, the financial services sector has been volatile, and the intra-sector correlations have been higher than in other industries, making financials less interesting in the portfolio construction of low volatility funds.

Among the other pitfalls of low volatility investing, Morningstar highlights a reliance on backward-looking risk data, high trading costs, limited participation, valuation risk, liquidity risk and high interest-rate sensitivity.

However, low volatility strategies are designed first and foremost to reduce risk compared with traditional market cap-weighted indices. Low volatility funds have undeniably delivered on that front. Morningstar data show that, on average, these funds have been able to significantly reduce the levels of volatility when compared with their respective category benchmarks and peers in the medium to long term, experiencing 11%-25% lower realised standard deviation versus the benchmarks during three- and five-year periods.

Low volatility strategies available to European investors have successfully reduced volatility and drawdowns in all developed markets. Europe- and EMU-focused low volatility funds have generated stronger volatility reduction and lesser drawdowns versus their respective benchmarks compared with US-focused funds. This is partly because US markets have experienced strong returns on the back of stable economic growth, while the European recovery has been sluggish and more vulnerable to market shocks, giving Europe and EMU low volatility funds more opportunities to shine.

But how do the returns of low volatility strategies stack up? During the past three years, low volatility funds on average have outperformed the MSCI indices in Europe, the eurozone, and globally but failed to do so in emerging markets and US equity.

The returns for a five-year period are not better. On a five-year basis, only two buckets, Europe and emerging markets equity, on average recorded an outperformance. Low volatility funds in the global and especially US equity buckets underperformed. It must be noted, however, that the number of funds with a five-year track record for most groups is sometimes substantially lower than for the three-year periods.

All things considered, it is fair to say that the relative returns of the low volatility strategies are a mixed bag. And especially in the highly efficient US equity market, they are less impressive than those obtained in other regions.

Nevertheless, low volatility funds shouldn’t be judged only on returns, as the main objective for this type of fund is risk reduction compared with traditional cap-weighted indices. A risk-adjusted gauge like the Sharpe ratio is a good way to measure the added value of these funds.

Over a three- and five-year period, almost all buckets outperformed their benchmarks on a Sharpe ratio basis. On average, the outperformance is quite significant for low volatility funds within Europe and eurozone equity. Again, US equity is the exception. Although on a three-year basis low volatility funds within US equity outperformed, they failed to do so on a five-year basis.

The paper concludes by saying Morningstar acknowledges the risk-reduction benefits that low-volatility strategies can bring to an investment portfolio over the long term; however, expectations that these strategies will provide significant risk reduction without any sacrifice of long-term return would be overly optimistic.

Moreover, the experience of each investor will be determined by the valuation at which they enter the strategy. Given the growing popularity and rising valuations of low volatility stocks, future rewards from this approach may be lower, and investors should set their expectations accordingly.

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