October 14, 2019: Low Volatility Factor ETFs

Oct 15, 2019 | All, Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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For regular SAA and TAA portfolios, the next re-balance will be on Monday, November 18, 2019. You can also find the re-balance calendar for 2019 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Low Volatility Factor ETFs

We continue our introduction to (smart) factor ETFs. In this newsletter, we will discuss low volatility factor. 

Low volatility stocks

Low volatility stock ETFs came out way before other ‘new’ factor ETFs including momentum and quality. In fact, these ETFs were introduced just after the 2008-2009 financial crisis bear market. Investors, fresh out of a violent market, were looking for something more stable. The so called low volatility factor and its ETFs were thus more welcome at that time. 

Investors usually make a mistake by simply interpreting this factor as a set of stocks with low(est) volatility. This is actually inaccurate. For example, MSCI defines its minimum volatility factor portfolio of stocks as follows: 

The MSCI Minimum Volatility Index is constructed using the Barra Optimizer3 in combination with the relevant Barra Equity Model. The optimization uses the Parent Index as the universe of eligible securities and the specified optimization objective and constraints to determine the optimal MSCI Minimum Volatility Index. The Barra Optimizer determines the optimal solution, i.e. the portfolio with the lowest total risk, using an estimated security co- variance matrix under the applicable investment constraints. 

Basically, the portfolio (i.e. stocks and their weights) is derived using an optimizer that tries to minimize the total risk under certain constraints such as maximum or minimum weights of sectors (or countries if it’s an international index). So the factor portfolio consists of stocks that, together, achieve lowest risk (or volatility). But individual stocks don’t necessarily have low(est) volatility. 

For example, on 9/30/2019, the MSCI US MV (Minimum Volatility) factor index’s largest position is Newmont Goldcorp Corp (NEM), a stock by no means has low volatility. However, since this gold mining stock has low or even negative correlation with other stocks, its addition can actually hedge out other stocks volatility and thus reduce the overall volatility. 

 MSCI points out that the factor usually consists of stocks that demonstrate the following characteristics:

  • Low Beta relative to the Parent Index
  • Lower Volatility than the Parent Index
  • Lower cap bias
  • Bias towards stocks with low idiosyncratic risk

So in general, these stocks still somewhat fit into investors’ first perception: stocks with low volatility. The following shows the top ten holdings of ETF USMV on 9/30/2019:

Again, one can see that the index is tilted to low risk stocks like those in consumer staples. But they do not necessarily have the lowest volatility themselves (otherwise, it would most likely heavily tilted to utilities type of stocks). 

Outperformance 

This factor does exhibit outperformance against a market cap weighted broad base index such as MSCI USA stock index or S&P 500 index. MSCI shows the following: 

In general, it has about 1% excessive annualized return over its index. Year by year: 

It was able to stay positive in both 2018 and 2015 and had a smaller loss in 2008. Unfortunately, it does not improve very much in terms of maximum drawdown (47% vs. 55%, see this) so again investors shouldn’t be mistaken by its name — this factor index is more about long term return outperformance, not much minimizing loss as its name might have suggested. 

Low volatility ETFs

MSCI minimum volatility and S&P low volatility are the two representative indexes. The following are the main US stocks low volatility ETFs:

Low volatility ETFs (as of 10/14/19):
Ticker Expense (AUM) YTD
Return**		 1Yr AR 3Yr AR 5Yr AR
USMV (iShares MSCI USA Minimum Volatility) 0.15% ($36 B) 22.8% 19.7% 15.1% 13.5%
SPLV (PowerShares S&P 500 Low Volatility ETF) 0.25% ($13 B) 25.1% 24.0% 15.0% 13.0%
VTI (Vanguard Total Stock Market ETF) 0.03% ($123B) 19.6% 10.1% 13.3% 11.2%
XMLV (Invesco S&P MidCap Low Volatility ETF) 0.25% ($3.5 B) 17.9% 14.7% 12.8% 14.1%
MDY (SPDR S&P MidCap 400 ETF) 0.24% ($19 B) 16.1% 3.9% 9.4% 9.4%
XSLV (Invesco S&P SmallCap Low Volatility ETF) 0.25% ($2.2 B) 15.1% 6.6% 11.0% 12.6%
IWM (iShares Russell 2000) 0.19% ($42 B) 12.9% -1.2% 8.5% 8.9%

The above table shows that these four largest low volatility ETFs for US stocks have large enough Asset Under Management (AUM) (thus, narrow bid-ask spread). We also list the respective market cap weighted benchmark (highlighted). One can see that all of the low volatility ETFs have done much better than their benchmarks for the past 1, 3 and 5 years, an impressive feat. 

To summarize, the low volatility factor does have its advantage and their ETFs are also good enough for portfolio construction. Together with value, quality, momentum and high yield, we believe factor ETFs can play an important role in most investors’ investment portfolios. 

Market overview

As expected, investors were expecting and excited to hear that a partial trade deal was achieved between the US and China. This has helped to sustain stocks at the current extended level. As company earnings reports for last quarter are in full swing now, it’s yet to see how bad the earnings decline (expected decline is now -4.6% for S&P 500 companies) is. The expectation has been revised lower several times now (from -0.6% to two weeks’ ago -4.1% to now -4.6%). We again call for staying the course and will respond to market conditions based on our plans. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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