Volatility funds come in two guises: exchange traded notes (ETNs), which track volatility indices such as the CBOE VIX, and exchange traded funds (ETFs), which aim to minimise volatility by tracking indices such as MSCI World Minimum Volatility. Investors in volatility ETNs have lost money in recent years while investors in volatility ETFs have enjoyed market-beating returns with lower risk.
Low-volatility ETFs have delivered a decade of strong growth and generated higher returns than their comparable broad market indices with lower volatility.
For example, over three years iShares Edge S&P 500 Minimum Volatility ETF (MVUS) has returned 130.7 per cent and SPDR S&P 500 Low Volatility UCITS ETF (USLV) has returned 79.3 per cent, compared with 71.7 per cent for the S&P 500. And iShares Edge MSCI World Minimum Volatility UCITS ETF (MVOL) has returned 73.9 per cent and Ossiam World Minimum Variance UCITS ETF (WDMV) has returned 62.1 per cent, compared with 55.5 per cent for MSCI World index.
A number of European equity low volatility ETFs have also beaten the MSCI EMU and MSCI Europe indices.
But low-volatility ETFs are not designed to beat broad markets. They are composed of stocks with a lower standard deviation than the broader index, and the correlations between stocks and sectors are taken into account to generate lower volatility than a parent index.
And low-volatility ETFs now look expensive, says Chris Brightman, chief investment officer at Research Affiliates, as they are concentrated on expensive, bond-like stocks, which could be affected by a shift to value-style or cyclical stocks if there is an interest rate rise or sentiment shift.
"Low-volatility ETFs have, on average over time, traded at a similar price to the market, but to date are trading at a massive premium to the market," explains Mr Brightman.
But low-volatility ETFs are not designed to beat broad markets. They are composed of stocks with a lower standard deviation than the broader index”
For example, iShares Edge MSCI World Minimum Volatility UCITS ETF is overweight consumer staples and healthcare, to which 14.95 per cent and 17.32 per cent of its assets are allocated respectively. By contrast, consumer staples and healthcare account for just 10.05 per cent and 12.3 per cent respectively of the MSCI World index. And the ETF trades on a price/earnings ratio (PE) of 22.03 compared with MSCI World index's PE of 21.7, as at 31 May.
But if defensive stocks re-rate the situation could change, so Mr Brightman says investors who bought into low-volatility strategies hoping for market-beating performance should be aware that low-volatility ETFs' outperformance of their parent indices can't last. And there are signs of this already: over one year the majority of global, US and European equity low-volatility strategies have underperformed the broader indices, after value-style stocks pulled away from quality growth in 2016.
IG's Oliver Smith says: "Minimum volatility ETFs tend to be overweight consumer staples, telecoms and utilities companies, and underweight financials and materials. You will definitely see some underperformance in minimum volatility strategies when interest rates go up, mainly because they are underweight financials. Their underweights to financials and tech stocks are just as important for understanding performance as their overweights to sectors like consumer staples."
But he doesn't think that low-volatility ETFs are expensive and says they should still fulfil their purpose over the long term, providing both portfolio diversification and lower-volatility returns.
"It is difficult to say whether these low-volatility stocks are overvalued," says Mr Smith. "We have had a fall in bond yields over time, but a lot of the market looks expensive - not just consumer staples stocks. I think minimum volatility strategies are worth holding for diversification purposes alone."
He points out that the active share of iShares Edge MSCI World Minimum Volatility UCITS ETF is 72 per cent, compared with iShares MSCI World UCITS ETF (IWRD), and adds: "With iShares Edge MSCI World Minimum Volatility UCITS ETF you are getting exposure to a lot of things you would not necessarily hold otherwise, and that is a good thing."
Performance of low-volatility ETFs compared with broad markets
| ETF/index | 3-month total return (%) | 6-month total return (%) | 1-year total return (%) | 3-year cumulative total return (%) |
|---|---|---|---|---|
| Amundi ETF MSCI Europe Minimum Volatility | 7.8 | 15.0 | 25.3 | 43.1 |
| iShares Edge MSCI Europe Minimum Volatility UCITS ETF | 7.9 | 15.3 | 25.7 | 43.0 |
| SPDR Euro Stoxx Low Volatility UCITS ETF | 10.8 | 18.9 | 34.7 | 53.7 |
| UBS MSCI EMU Low Volatility UCITS ETF | 10.8 | 17.4 | 33.7 | |
| MSCI Europe Index | 7.8 | 14.9 | 43.2 | 38.4 |
| MSCI EMU index | 6.4 | 12.7 | 35.8 | 33.6 |
| db x-trackers MSCI USA Minimum Volatility UCITS ETF | 3.0 | 5.7 | ||
| iShares Edge S&P 500 Minimum Volatility UCITS ETF | 1.9 | 3.5 | 18.5 | 130.7 |
| SPDR S&P 500 Low Volatility UCITS ETF | 3.1 | 5.0 | 15.9 | 79.3 |
| MSCI USA index | 2.0 | 3.2 | 26.5 | 71.0 |
| S&P 500 index | 2.0 | 3.0 | 26.3 | 71.7 |
| Vanguard Global Minimum Volatility UCITS ETF | 3.5 | 5.5 | 22.4 | |
| iShares Edge MSCI World Minimum Volatility UCITS ETF | 3.0 | 6.5 | 14.7 | 73.9 |
| db x-trackers MSCI World Minimum Volatility UCITS ETF | 3.0 | 6.5 | 18.0 | |
| Ossiam World Minimum Variance UCITS ETF | 2.7 | 4.2 | 14.6 | 62.1 |
| MSCI World index | 2.96 | 5.7 | 28.0 | 55.5 |
Source: FE Analytics, as at 28.06.17
