Low Volatility ETFs: So Far So Good

Academic research has found that it “beta doesn’t always line up” that it is possible to construct portfolios that produce alpha relative to the cap weighted market index : higher risk adjusted returns. Note that the strategy is not expected to outperform the market but rather to offer greater return relative to the risk of the portfolio. Thus the expectation is that they will outperform the market cap index in stable or down markets and outperform in up markets but produce higher return per unit of risk (alpha). You can find a discussion of this strategy by one of its principal academic advocates Robert Haugen here 

ETFs replicating this strategy have been in the market a bit over a year and so far have met their expectations. Additionally although they correlate strongly with value stocks (there is considerable overlap in holdings) they produce meaningfully different risk/retun characterisitcs.

Here is the one year total return (top)and volatility ( bottom) a measure of risk) for one year for. VTI the total stock market, VTV large value US, SPLV the S P 500 low volatility strategy and USMV the total US market minimum volatility ETF as well as AGG the total bond market index: 

Note that although the  low/minimum volatility ETFs have produced lower absolute returns they have delivered on their goal of better risk adjusted returns. They have produced a bit over 80% of the return of the cap weighted index with less than 70% of the risk.

The international minimum value portfolios in emerging markets EEMV and developed markets minimum volatility EFAV. In the developed markets EFAV has given better risk returns than the cap weighted EFA 

Both the emerging and developed international one year return (top) and risk (volatility) are below

and in emerging markets EEMV has achieved the holy grail of inveting more return and less risk vs. the cap weighted EEM.

The wide divergence between the 2 emerging markets instruments can be traced to the divergent sector weightings(below). EEMV has significantly lower weighting in the commodity industries : energy and basic materials which have high volatility due to the volatility of commodity prices. Given the short history of these instruments it is not hard to imagine a period in which strong and volatile commodity prices produced higher return and higher risk for EEM. Given the fickle nature of commodity prices on should be hesitant to draw too many conclusions.

EEM Sector Breakdown Sector Percentage Financial Services 21.65% Technology 14.43% Basic Materials 11.25% Energy 10.11% Consumer Cyclical 8.62% Consumer Defensive 8.09% Communication Services 7.85% Industrials 7.01% Utilities 2.94% Real Estate 1.75% Health Care 1.04%

EEMV Sector Breakdown Sector Percentage Financial Services 22.96% Consumer Defensive 14.20% Communication Services 13.42% Technology 8.24% Consumer Cyclical 7.51% Industrials 7.46% Energy 6.78% Utilities 5.71% Basic Materials 4.68% Health Care 4.04% Real Estate 1.65%

How to use these strategies:

There are two major uses for these instruments:

• 1.       Constructing a lower risk/lower prospective return equity strategy. For investors looking for lower potential losses in a down market and willing to forego higher returns in strong bull markets this would be a good substitute for part of their equity holdings.

2.      

• “     Risk Budgeting” based on the data a minimum/low volatility strategy could allow an investor to increase his equity allocation relative to lower volatility fixed income and increase portfolio return per unit of risk.