Is it time for low-volatility ETFs?

One of the issues that drives sub-par returns in volatile markets is when investors attempt to time the market. Investing is difficult, and even the smartest people get affected by the cognitive biases. Moving in and out of the markets at the wrong times can deliver significant under-performance over time.  

Introduced in 2011, low-volatility exchange traded funds (ETFs) can help with this as they are designed to provide an anchor during big market swings.

Low-volatility ETFs hold relatively stable stocks to provide a diversification tool for investors to maintain market exposure whilst taking on less risk. They do this through diversification across a broad range of sectors while optimising the portfolio/holdings to reduce potential losses in a falling market. 

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MSCI, which runs indexes of this type, has defined four key characteristics of low-volatility ETFs:

  • Low beta to the parent index;
  • Low volatility to the parent index;
  • Lower market cap bias; and
  • Bias towards stocks with low idiosyncratic risk (or stock-specific risks).

Leveraging MSCI indexes, BlackRock’s iShares business has two such minimum volatility funds listed on the ASX: one that focuses a decreasing international equity volatility (ticker: WVOL) and one closer to home that seeks to reduce risk when investing in Australian equities (ticker: MVOL).

How does it work?

Minimum volatility (min vol) is a type of smart beta strategy: it provides a low-cost, rules-based, and transparent way to produce an investment outcome different from a traditional market capitalisation-weighted portfolio.

In layman’s terms, the strategy aims to smooth out returns by holding a diversified portfolio of companies across a range of sectors that display lower volatility. 

The minimum volatility index is constructed by starting with the parent index, for example, the MSCI World Index or MSCI Australia Index, and optimising for the lowest absolute volatility within a given set of constraints. This ensures that country and sector diversification is substantially maintained, prevents unintended bias, and controls turnover.

Historically, minimum volatility indices have shown lower beta and volatility characteristics compared to their parent index.

How to use minimum volatility ETFs as part of your investment strategy

The key reason to consider adding low or minimum volatility products to an investment portfolio is for times when remaining fully invested makes sense, however, there is a desire to decrease risk.

Another reason to include a minimum volatility strategy is when you need to increase the equity weighting in a portfolio, though in doing so, you do not want to increase risk.

Brad Frankham, a financial adviser based in Newcastle, said: “We have begun to notice the nature of our client conversations shifting. With volatility at record lows in recent times, clients have been happy to sit and watch. However, as geopolitical risks play out across the world the attitude towards risk is changing. We are looking at minimum volatility products as an avenue to reduce our clients’ portfolio risk while not having to be so focused on timing the market.” 

A case study

A direct example of this is the iShares World Minvol product (ticker: WVOL), which only participated in 59 per cent of the fall in the benchmark over the last 10 years. This means that, over the course of that period, when the index was down 100 points, WVOL would only fall by 59 points.

That being said, the strategy is designed to reduce risk and will therefore restrict participation on the upside. In this case WVOL would only participate in 73 points for every 100-point rise in the index.

This is similar for the Australian Minvol strategy (ticker: MVOL) though, due to the smaller scope of only 104 constituents in the Australian strategy compared to world’s 537 constituents, we don’t see as much downside capture, meaning it doesn’t mitigate the risk as well. 

Either way, in the case of a bear market, a minimum volatility strategy is designed to capture a smaller percentage of a drawdown and hence improve overall portfolio risk. 

Minimum volatility strategies also have their drawbacks. As with any stock or factor screening methodology, there can be some biases toward sectors or countries. There is also concern around correlation between styles, such as growth and momentum.

Sectors such as utilities and consumer staples are generally regarded as lower volatility, defensive sectors, and thus may feature heavily in a low vol strategy. The same apprehensions exist around country and even regional biases.

Emerging markets, for example, have a heavier composition of technology stocks versus Europe, meaning that emerging markets may be underrepresented in a min vol strategy. Index providers, such as MSCI, utilise an optimisation framework to limit these biases across the indices they manage.

There is also an issue of high turnover at the rebalancing of an index and hence why the index providers need to ensure they optimise turnover constraints.  

Chart two shows a combination of BlackRock ETFs utilising the minimum volatilty indices instead of the parent indices, showing a reduction in volatility .

The main points for investing in low or minimum volatility strategies are: 

  1. They deliver market-like returns, but with less risk than the overall market

Since inception, the four original US Min Vol ETFs have delivered 15-20 per cent less risk than their broader market indexes on annualised basis. They have captured less downside during volatile markets but also less upside during market rallies – they did what they were designed to do.

  1. They provide improved risk-adjusted returns versus other funds

Since inception, min vol ETFs’ risk-adjusted returns (a measure of how much risk is involved in generating a security’s return) are superior to 99 per cent of large-cap domestic equity mutual funds and ETFs. 

  1. They help investors stay invested long term

Many investors are driven by emotion, piling into the market at their highs and selling off near their lows. Because Min Vol ETFs capture less downside during market volatility, they have the potential to help investors weather market turbulence and stay invested long term.

  1. They can be used as portfolio building blocks

Beyond being potential risk reducers, min vol ETFs can function as building blocks for a portfolio’s foundation. They seek to track MSCI indexes which have sector and country exposures that are tightly constrained to +/- five per cent of a broad market index. So the ETFs offer similar diversification as the broad market.

  1. They are not a new strategy

The funds were founded on a principle called the “low volatility anomaly” which was first identified in the 1970s. The low volatility anomaly is largely driven by the investor’s tendency to underpay for lower-risk stocks and overpay for higher-risk, more volatile stocks.

This results in lower-risk stocks being less vulnerable to wild swings in price.

Minimum volatility strategies allow investors to remain fully invested while mitigating the risks of heightened market turbulence.

This is useful to those who have limitations on the amount of cash that can be held in portfolios. This can be a powerful tool for those clients who are mandated to be fully invested and/or having difficulties finding the right alpha hedging tool, yet want to reduce market beta.

Minimum volatility ETFs are a smart beta strategy

One of the fastest growing segments in the financial industry, smart beta has become a ubiquitous theme in investment management today. But is smart beta just another buzzword or marketing invention?

The expression “smart beta” is new but the concepts behind it are not. Fundamentally, smart beta has its roots in factor investing, itself the subject of long-standing academic research. Its roots go back to academia studying the Capital Asset Pricing Model (CAPM) in the 70s and 80s.

Factor-based investing or smart beta strategies seek to capture broad, persistent drivers of returns.

Combining elements of both traditional passive and traditional active investing, smart beta strategies seek to out-perform traditional index strategies through rules-based investing strategies that differ from the traditional market cap-weighted indices. 

The styles that are used by these alternate indices are familiar to most investors and range from momentum to quality to company size to minimum volatility. A lot of this is driven by the CAPM model and trying to get closer to the efficient frontier to drive outperformance or to reduce risk.

Active, passive or something in between?

A common question surrounding smart beta is if these strategies are active or passive. The truth lies somewhere in between.

Smart beta strategies are active in that they attempt to enhance risk-adjusted returns through exposures to proven drivers of return.

At the same time, these strategies resemble traditional passive strategies in that their implementation is transparent, systematic and rules-based. This means that portfolio construction is based upon a set of rules that are widely disclosed and require little or no discretionary input from portfolio managers.

These strategies tend to have lower fees and higher capacity than traditional active strategies.

In Australia, smart beta investing is still in its infancy. However, across the globe it is something that has seen material inflows and is part of many advisers’ investment toolkit.

In FTSE’s most recent annual smart beta survey, nearly 80 per cent of investors were aware of smart beta with over 50 per cent having used it in their portfolios. These numbers are similar across the UK and Canada. 

The top reasons advisers in the US are using smart beta is they currently see these ETFs as the best vehicle to implement into portfolios with one or more of the following three key strategies: pick up alpha, help diversification, and provide downside protection.

At present, there are less than 15 smart beta ETFs available for both international and domestic exposures. However, investors are growing increasingly smart about how they add smart beta to their portfolios, often complementing both active and passive strategies. 

Globally, the trend of 2018 may not be just investing thoughtfully in factors as discrete smart beta positions, but putting factors to work within other types of funds. This could mean putting retirement savings into funds powered by smart beta, balancing style factor exposures across equity funds, or using smart beta ETFs to refresh style box holdings. 

Global assets invested in smart beta surpassed to US$750 billion in 2017 and BlackRock sees it growing to US$1.4 trillion by 2022. 

Christian Obrist is head of iShares Australia and Blair Hannon is an iShares ETF strategist.


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