If you were told there was a low-cost passive fund out there which outperforms the market and does so with less volatility than equities, you might well scoff.
But a look at some low volatility exchange traded funds shows some have indeed succeeded on both fronts.
The ETFs track indices designed to offer similar equity exposure to a parent index, such as the MSCI Europe or MSCI World, but with lower risk. They are expected to minimise losses but not fully take part in large upside swings. However, in the past three years, the ETFs have delivered far higher total returns at far lower volatility than their original counterparts based purely on stock, sector and country allocation.
Amundi ETF MSCI Europe Minimum Volatility (MIVO), iShares MSCI World Minimum Volatility UCITS ETF (MVOL) and iShares MSCI Emerging Markets Minimum Volatility ETF (EMMV) all beat their original counterparts significantly over a one- and three-year period in return terms.
Cumulative total returns of minimum volatility and original ETFs
ETFs | 1-mth | 3-mth | 6-mth | 1-yr | 3-yr |
Amundi ETF MSCI Europe | -3.6 | -6.1 | -9.8 | -8.0 | 10.2 |
Amundi ETF MSCI Europe Minimum Volatility | -0.1 | -0.1 | -0.6 | 0.8 | 28.0 |
iShares MSCI Emerging Markets Index | -3.8 | -4.4 | -5.4 | -11.8 | 9.4 |
iShares MSCI Emerging Markets Minimum Volatility Index | -1.8 | -1.0 | -3.2 | -6.8 | 21.6 |
iShares Core MSCI World UCITS ETF | -4.7 | -4.8 | -5.4 | -4.3 | 26.3 |
iShares MSCI World Minimum Volatility UCITS ETF | 1.1 | 4.3 | 5.3 | 5.7 | 42.1 |
Index : MSCI Emerging Markets | -2.9 | -9.8 | -10.7 | -19.4 | -19.9 |
Index : MSCI Europe | -3.7 | -6.2 | -9.9 | -8.5 | 9.3 |
Index : MSCI World | -4.2 | -4.3 | -5.0 | -3.9 | 26.7 |
Source: FE Analytics, as at 5.02.16
The stocks and sectors which won cautious ETFs the race
Unlike actively managed low-volatility funds, there are no hedging tools or derivatives used in low volatility ETFs. They are created by identifying the volatility levels of individual stocks from the parent index and then working out which combination of these make for the least rocky ride.
In the past three years, sectors such as energy and commodities have been exceptionally volatile which has opened up a chance for low volatility ETFs, which can dodge these sectors, to shine.
Sector and top 10 stock comparisons - minimum volatility ETFs and originals
iShares Core MSCI World | % weighting |
Apple | 1.8 |
USD Cash | 1.53 |
Microsoft | 1.37 |
Exxon Mobil | 1.05 |
Johnson & Johnson | 0.93 |
General Electric | 0.89 |
Wells Fargo | 0.82 |
0.8 | |
Nestle | 0.79 |
Alphabet | 0.75 |
iShares MSCI World Minimum Volatility | % weighting |
AT&T | 1.63 |
Southern | 1.49 |
Verizon Communications | 1.45 |
Johnson & Johnson | 1.42 |
Procter & Gamble | 1.4 |
McDonalds | 1.3 |
General Mills | 1.29 |
Consolidated Edison | 1.21 |
Automatic Data Processing | 1.18 |
Nestle | 1.17 |
Amundi ETF MSCI Europe | % weighting |
Financial Services | 21.14 |
Consumer Defensive | 14.88 |
Healthcare | 14.21 |
Consumer Cyclical | 11.19 |
Industrials | 10.27 |
Basic Materials | 7.09 |
Energy | 6.11 |
Communication Services | 5.5 |
Technology | 4.36 |
Utilities | 3.81 |
Real Estate | 1.44 |
Amundi ETF MSCI Europe Minimum Volatility | % weighting |
Consumer Defensive | 19.76 |
Healthcare | 18.39 |
Financial Services | 16.75 |
Communication Services | 10.94 |
Consumer Cyclical | 9.3 |
Utilities | 8.84 |
Industrials | 7.58 |
Real Estate | 2.92 |
Basic Materials | 2.44 |
Technology | 1.55 |
Energy | 1.53 |
Source: Morningstar, as at 31.12.15
According to Todd Mathias, global product strategist at iShares: "Looking at how minimum volatility strategies position themselves in today's market, they are overweight healthcare, utilities and staples and underweight things like energy. You are going to get higher quality securities and have a level of downside protection.
"It is a more concentrated portfolio - you remove about 75 per cent of the securities on average [from the parent index] and go from 1,600 to around 350 so you do have a little more idiosyncratic risk but that is still a large number of securities."
Nicolas Fragneau, head of ETF product specialists at Amundi, agrees stock picking "drives the difference in performance".
"But low volatility portfolios are not necessarily constituted through having just low volatility stocks," he says.
"You can have two high volatility stocks but they wont' be driven by the same market trends so will cancel each other out. It's about selecting the overall portfolio with minimum volatility."
The fact that the past three years have been volatile helps explain why they have outperformed in that time. But it does not fully explain the long-term outperformance of indices like the MSCI World Minimum Volatility index, which in a 10-year period has trounced the MSCI World.
Less pain, more gain
Why it works in the long term
The key seems to be some participation in upmarkets mixed with smaller drawdowns when falls occur.
"If you look at upside capture ratio versus downside capture during the past 15 years, MSCI World Minimum Volatility, on average, has captured 69 per cent compared to 100 per cent for the parent, so you will lag the market," says Mr Mattias.
"But if the market goes down, Minimum Volatility captures 56 per cent of it, so you get an asymmetry."