Recent underperformance of low-volatility funds is tied to their bias toward defensive stocks and lack of financials.
Low-volatility strategies such as the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) and the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) have been incredibly popular with investors this year. But these funds have started to show underperformance that might sully their appeal.
SPLV is by far an investor favorite. With more than $4.9 billion in assets and average daily trading volume north of $80 million, there’s little question that the fund is well liked by investors. However, something interesting has occurred.
As part of our “Fit” section in the ETF Analytics system, we run a regression analysis of each ETF against a designated segment benchmark. In the case of SPLV, its segment benchmark is the MSCI USA Large Cap Index.
Interestingly, for the past year, SPLV has maintained a statistically significant 12-month alpha in the range of 6 percent against the MSCI USA Large Cap Index.
Although SPLV is a passively managed fund tracking its own underlying index, when measured against a plain-vanilla large-cap index, the fund’s strategy and sector tilts can lead to significant outperformance for a period.
This week, however, the SPLV finally lost its alpha—and it makes sense given the fund’s latest fallback in the last month relative to the MSCI USA Large Cap Index.
Last week, we also saw the same thing happen to USMV. Unlike the large-cap-focused SPLV, USMV selects its low-volatility holdings from a U.S. total-market universe. As a result, we ran USMV against the MSCI USA Investable Markets Index.
Like SPLV, USMV maintained a statistically significant 12-month alpha ranging between 4 and 9 percent. This indicated the fund’s passive low-volatility strategy significantly outperformed the broader U.S. market.
However, in the past month, it too faced a significant pullback when compared against our segment benchmark.
So what exactly is driving the force behind the reversals in “alpha” that we’re beginning to see in the low-vol space?
Looking at SPLV gives some greater insight.
SPLV holds the 100 least-volatile stocks in the S&P 500 with no mechanism to adjust sector biases or tilts. As a result, the low-vol fund dedicates nearly one-third of its portfolio to the utilities space. We did a quick rundown of sector contributions to SPLV’s price drop in the past month and here’s what we found:
The utilities sector was by far the most dominant factor in the group—but there’s an even bigger story here.
Utility stocks have taken a beating in the past few months as investors moved out of dividend-paying equities in favor of Treasurys, which are starting to see higher yields. As Jonathan Cheng at the Wall Street Journal pointed out, the recent market has been heavily driven by defensive stocks, and it looks like investors are finally turning to cyclical stocks.
However, utilities exposure isn’t unique to SPLV.
As you can see above, it’s a feature that has affected the SPDR S&P 500 ETF’s (NYSEArca: SPY) portfolio in the past month as well.
The key difference here between SPLV and SPY is SPY’s exposure to financial firms that SPLV has discarded in its search for low-volatility stocks. As a result, SPY benefited from the rally in its group of financials relative to the group of financials in SPLV.
The inherent bias toward defensive stocks in USMV and SPLV was the backbone behind the funds’ low-volatility strategies.
However, if yields continue to climb as we’ve seen in recent weeks, these biases might undo the outperformance that investors have benefited from in the past.