Sometimes the simplest questions are the most important to ask. Such is the case when I looked at the flows into low-volatility funds last week as part of the regular checkup on ETF fund flows.
While the rest of the ETF market is pulling in money by the fistfuls, low-vol funds, as a group, are actually having a pretty awful year. Through the end of February, they were down $578 million in assets.
The bulk of the outflows happened in two funds that anchor the space, the PowerShares S&P 500 Low Volatility Portfolio (SPLV), which lost $239 million through February, and the iShares Edge MSCI Min Vol USA ETF (USMV), which lost a whopping $702 million.
So what’s going on here? The performance so far hasn’t been awful—with the S&P up 5.94%, SPLV and USMV returned 5.14% and 5.86%, respectively. Not beating, but hardly going backward—which led me to ask, when exactly are these things supposed to ‘work’ versus the market?
It turns out, there’s a lot of research on when certain factors work out there, including solid academic work from folks like Cliff Asness at AQR and the quants at BlackRock. Most of that work talks about theories of why low-vol stocks occasional outperform, with a lot of handwringing about whether low-vol stocks are “expensive.”
Volatility For Low Vol?
But I was more curious about when they might outperform, and whether there’s anything to be learned about investor psychology here. I wanted to just keep it simple (because I’m not an academic), so I just looked at SPLV over the last five years, and how it’s done relative to the actual volatility of the market, proxied by VIX:
Here we’re looking at the monthly returns of SPLV versus SPY. I think that’s a pretty good measurement of “did it work?” The correlation here isn’t perfect, but I think it’s pretty illustrative. Almost every spike in VIX shows a concomitant month where the fund beat the market. I don’t think I even need to include the line for market returns—we all know when VIX tends to spike: when markets go down.
That suggests that low-volatility investment is essentially serving as a kind of long-term bet on volatility itself—you need volatility to go up for the strategy to deliver on the promise.