Analysis Date: February 12, 2018
In the wake of the recent crisis, we wondered: how have off-the-shelf low volatility ETFs performed? Do they deliver as promised, i.e., market exposure that helps on the upside, along with positive active returns when the market turns south. We also wanted to see if they were more or less volatile than the market overall.
Our study focused on three low or minimum volatility ETFs:
LGLV: SPDR SSGA US Large Cap Low Volatility Index ETF
SPLV: Powershares S&P 500 Low Volatility Portfolio
USMV: iShares Edge MSCI Minimum Volatility USA ETF
While all three ETFs generated positive returns, they underperformed the Russell 3000 benchmark over the past five years. As the US market posted record after record and volatility hit historic lows at the end of 2017 and into this year, all funds’ relative returns tanked further. The worst performer was SPLV, which recorded an active five-year cumulative return of -14.6% as of February 12, 2018. The best performer was USMV with an active return of -5.5%. All three funds’ relative returns rebounded in the past three weeks, but not enough to make up for their large drop in return in earlier months. So far, these low volatility ETFs seem to have offered small rewards to investors seeking to capitalize in highly volatile markets. In other words, if investors’ goals were to outperform in a market downturn, the ETFs delivered, but their underperformance in the good times might not have been worth it.
Subjecting our ETFs to a factor-attribution analysis of their five-year active performance, uncovered that specific returns were the main culprit for the negative active return of all three funds, contributing -13% to -16% to the active returns. Style contributions lifted the performance of all three funds, while industry bets pushed LGLV and SPLV down and had a small positive contribution to USMV.
The negative exposure to Volatility (-) contributed the most positively to the active return of all three funds: 14% to LGLV, 9.5% to SPLV and 6% to USMV. Market Sensitivity was the second-largest contributor among style factors, recording a 2% to 7% positive contribution. Medium-Term Momentum (-) was the largest detractor from the ETFs’ active returns. All funds had a negative exposure to Size, holding stocks that were on average smaller than those in the Russell 3000. This small-cap bias hurt LGLV and USMV over the past five years, but slightly helped SPLV. In addition, while the names of these funds appeared similar to each other, they each had quite different exposures, which in turn meant differential performance.
When we focused on the 7-day period between 1-8 February 2018, when the US market went into a tailspin, the picture was quite different from that for the five-year period. All three ETFs recorded positive 7-day cumulative active returns: 0.87% for LGLV, 0.66% for SPLV and 0.63% for USMV. Style factors were the drivers of the positive active returns. Industry and Specific factors had marginal contributions, both negative for SPLV and USMV. The negative exposures to Volatility, Size, and Market Sensitivity were the main contributors to these positive 7-day active returns.
The ETFs’ total risk has surged with that of the overall market over the past couple of weeks, as measured by Axioma’s US4 medium-horizon fundamental model. Active risk did not change as much, and USMV saw a small decline in tracking error during this period.
Risk characteristics varied by fund, but a point-in-time risk analysis on February 12, 2018 revealed some commonalities. To start, Industry bets accounted for almost an equal proportion of risk as Style risk, with Specific risk contributing relatively little.
The largest proportion of Style risk did not come from the ETFs’ negative exposure to Volatility, but from the negative exposure to Market Sensitivity. Only SPLV and USMV got the second-largest proportion of risk from their low volatility bets. The small-cap bias added a substantial amount of variance to LGLV.
For investors who expect continued market volatility driven by declining stock prices, these three ETFs seem to offer downside protection, but that protection comes from different sources. The magnitudes of the bets differ substantially, and investors must consider the source(s) of expected underperformance to ensure the ETF aligns with their views.