Mirror, mirror on the wall, whose low-vol fund is best of all?
MSCI, widely considered the leading provider of global indexes, produced a white paper earlier this year touting the superiority of its minimum-volatility indexing methodology, which iShares currently uses in four ETFs launched in October.
MSCI’s paper, which shows that its minimum-volatility index massively outperformed the MSCI USA Investable Market Index—the broader benchmark of U.S. stocks that the minimum-volatility screen is based on—couldn’t be more topical. It comes at a time of heightened anxiety for investors, who are clearly receptive to ways of managing ongoing uncertainty in global markets. A look at the PowerShares S&P Low Volatility Portfolio (NYSEArca: SPLV), which has become a $1.55 billion fund in about 10 months, hammers home that point quite dramatically.
The iShares funds that use MSCI’s minimum-volatility indexes don’t have nearly the assets of SPLV, and neither does another low-volatility product from Russell. But that doesn’t mean officials from MSCI and Russell are waving a white flag of surrender. Instead, they both argue that their respective indexes do a better job of isolating specific risk factors than does the one on which SPLV is based.
While that may be true, PowerShares’ SPLV was first to market, which has historically been a huge advantage in the ETF industry. Moreover, from a returns perspective, last year SPLV came out ahead of both the iShares MSCI USA Minimum Volatility Index Fund (NYSEArca: USMV) and the Russell 1000 Low Volatility ETF (NYSEArca: LVOL). More precisely, SPLV’s index returned 14.8 percent last year, while USMV’s MSCI index rose 13.1 percent and LVOL’s Axioma index rose 6.4 percent. We had to look at backtested index returns, because none of the funds existed for the whole year, making comparing fund returns close to meaningless if not impossible
Another challenge for both iShares and Russell is that SPLV’s index methodology appears to be simpler and easier to understand—and probably easier for advisors to explain to prospects and clients. SPLV is composed of the 100 least-volatile stocks on the S&P in the past 12 months, and recalibrates its security selection quarterly. USMV and LVOL employ a methodology that isolates volatility more precisely, which is of interest to investors who are trying to track different risk factors within their larger portfolios.
Although SPLV won on returns and in assets under management, the basic point of MSCI’s paper is undeniably true; namely, that the 13 percent return of its minimum-volatility index last year beat the returns on its broader MSCI USA Investable Market Index by almost 11 percentage points.
In other words, the MSCI minimum-volatility screen worked quite well when financial markets went into turmoil last summer after Standard & Poor’s downgraded U.S. debt; the eurozone’s debt crisis threatened to send the global economy into recession; and gold reached a record near $1,900 a troy ounce.
“When markets crash, it can do very well,” Frank Nielsen, MSCI’s executive director for equity and applied research, said in a recent telephone interview. “And when markets rally … the index can underperform. But, more importantly, in the long run and over most periods, it has historically performed similarly or slightly better than cap-weighted indices.”
The data certainly confirm Nielsen’s assertion about underperformance in a rallying market. This year, since the market has been largely on a steady upward trajectory, the low-volatility funds are underperforming the broad market. Now, instead of having to look at indexes, we can look at actual ETFs, as they’ve all been up and running in the time period we’re looking at.
For example, while the SPDR S&P 500 ETF (NYSEArca: SPY) has risen 11.6 percent since the start of the year, SPLV has returned 2.04 percent, and LVOL and USMV are up 5.45 percent and 5.46 percent, respectively, according to data on Google Finance.